Ray Hendon’s Economics Blog

Predictions for the American economy are all over the map. The most optimistic prediction I see calls for the first half of 2009 to continue its decline, with unemployment reaching 7-8% by the end of June. Recovery will begin in the second half, and the economy will end the year with a net growth of 1% to 1.5%.

A less optimistic outlook sees the decline continuing until the third or fourth quarter of the year, with net growth for the year as at or near zero and unemployment reaching as much as 8% to 9%, with even 10% a possibility.

The most pessimistic projections see the recession lasting through the entire year, with the highest level of unemployment reaching from 10% to 12%. A few of the pessimistic school see an even more protracted downturn, lasting as long as to 2011. This group sees negative growth for all of 2009 and even through 2010 in some cases.

Breadline in N.Y. in 1930

I don’t pretend to know how this will play out. I have no experience with an economy such as we find ourselves in today. We had bank failures in the 1930s depression, but they were not like those of today, where the loan base of our largest banks was over-valued to unprecedented levels. The final analysis of today’s crisis is that many American banks, including all the giants, need massive recapitalization. The problem is, with the economy in a tailspin, investors with the capital to spend are in no mood to trust the banks. When the same fools who got us in this situation are still calling the shots, it is not hard to see why there is a low level of trust among potential investors.

There is no doubt in my mind as to the seriousness of our situation. Our economy is in a free fall for now, and there is nothing in place that is going to stop the fall. Paul Krugman, Nobel Prize winner in economics for 2008, phrases it this way:

“The fact is that recent economic numbers have been terrifying, not just in the United States but around the world. Manufacturing, in particular, is plunging everywhere. Banks aren’t lending; businesses and consumers aren’t spending. Let’s not mince words: This looks an awful lot like the beginning of a second Great Depression.” (NT Times, January 4, 2009)

The only thing on the horizon that promises some relief is the stimulus (or recovery) plan of the incoming Obama Administration. It promises up to $1 trillion in new federal spending, and, from the looks of it, it needs to be that much. Mr. Krugman’s concern is that the size of the package will be resisted by a Republican minority forcing a delay in its passage and possibly a reduction in size. Either of these scenarios would be hurtful for the economic recovery.

A reduced package could result in a slowed down recovery, or, even worse, simply a reduction in the rate of our fall. In other words, the worst case would be a recovery package too small to stop the fall.

The fear of a continuing fall is not out of the question. If deflation becomes a problem, it feeds on itself. Purchases by businesses and consumers are put off, since falling prices encourage waiting for lower prices. This causes businesses to cut production even more, resulting in more unemployment and even lower spending ahead. This type of self-perpetuating spiral is, indeed, a fearful prospect. If left unattended, it could take years, even a decade, for the economy to self correct and begin a recovery.

Feeding on this scenario are some serious barriers to a fast recovery. Economic expansion is being held back by four major factors:

1. Home prices and investment values are falling. Both of these tend to retard spending, as the reverse of a wealth effect, meaning that when households feel less wealthy, they tend to cut back on spending.

2. Declining employment opportunities. Jobs are the major source of income for Americans. When there are fewer jobs, there is less spending. With an increasing level of unemployment, it causes spending to fall and optimism to turn to pessimism.

3. Declining sales to foreigners. With the world-wide recession in play, other countries are also feeling the pinch, and they cut their demand for products they buy from other nations. In the United States, our largest exports include airplanes, computers, wheat and corn. All suffer when there is a global downturn. Producers of these goods in America will feel the pinch, cutting back on production and employment.

4. Business inventories and expansion will continue falling as long as there is insufficient demand for new products. That is where we are now, and both inventories and new plant and equipment spending are expected to be cut back as long as there is low consumer demand.

The economy needs a huge infusion of spending to off-set these tendencies, and the spending of last resort is the government. The federal government, in particular, can issue contracts to build new roads, schools, hospitals and more. This will put income into the economy, and it will increase the level of optimism in the job market. It can be the major player in a recovery. We need a big dose of this remedy now. I encourage everyone to get behind a quick enactment of the recovery program. It could make the difference between the first and last scenarios shown in the earlier paragraphs. 7-8% unemployment is not a killer. 10-12% is! We need to put a cap on this destroyer of economies, and we need to act soon.

Many journalists, when writing about the economy, focus on the broadest pictures:  Gross National Product, total Non-farm employment, etc.  But, sometimes the big picture needs supplementing with a narrower focus. 

In looking at employment, for example, it helps to break the total employment picture down into three primary sectors.

• Cyclical Services, which include information services, fire, professional and business services plus leisure and hospitality (sports, hotels, gambling, e.g.),  Employment in this sector follows the general business cycle.
• Acyclical Services, which include health, education, other services, and government.  These services, as the name implies, do not vary with the business cycle as much as the other sectors.
• Goods, i.e., produced goods, which are generally measured with  industrial production figures.

Below is a graph of these three sectors, measured in total payrolls for each sector as annualized six-month changes.  This chart shows how wide a path unemployment is cutting through our economy.  Most everyone is feeling it.

The chart is also a good explanation why government spending is so important in acting as a counter cyclical component for our economy.  While the private payrolls expressed in the cyclical and manufacturing sectors are zigging, government spending and payrolls can zag.  This approach to leveling the effects of business cycles has keep recessions at a more moderate level since the Great Depression of the 1930s.

Few economic events stir up fear faster than deflation.  In a technical sense, deflation is merely the opposite of inflation; overall prices drop rather than rise.  It doesn’t mean that all prices drop, but the average of all prices will drop during deflation.

The fear factor that deflation brings is because it is associated with bad economic times rather than good times.  The NY Times graph below does a good job of showing this association.  Note that in the shaded areas, areas when the economy is in recession, is also the time, for the most part, when price deflation occurs.  There are brief periods where year over year prices may fall for a short time without being in recession, but in all cases where falling prices lasted for a long time, a recession or depression was in

process.

The economics behind this phenomenon are simple: falling prices discourage spending, since a consumer will reasonably conclude that a by waiting to buy, a better price could be had.  If you are contemplating buying a new car, for example, wouldn’t it be wise to wait until prices fell?  Any good or service that is not needed immediately, then, can be postponed.  When most everyone in the economy reaches the same conclusion, then you begin a price spiral downward that makes the already bad economy much worse.  Manufacturers have to cut prices further trying to stimulate sales of existing inventories, which is also usually accompanied by further cuts in production and cuts in the number of people on the payroll.  A downward spiral is, indeed, a fearful state of affairs for an economy, and it proved to be difficult to break out of in the Great Depression of the 1930s.

The good news is that WWII taught us the secret of defeating deflation.  Now, it is seen as comparatively easy to break deflation by simply printing more money or by the Federal Reserve System buying bonds.  More money in circulation will force prices up, so monetary policy and fiscal policy can work to put more money into circulation and more income to spend.

A countervailing fiscal policy has characterized economic policy of all the developed nations since WWII.  Monetary policy has been used to control prices, especially after the contribution of Milton Friedman in the 1970.  Using the two tools, monetary policy to keep price inflation and deflation under control and fiscal policy to keep aggregate demand healthy, there have been fewer recessions and more moderate price crises in decades after WWII.  Notice in the chart above the length between recessions from earlier in the Century.

We are undoubtedly in a period of deflation for now, but actual price declines have been measured for only a couple of months.  Deflation would become a serious problem only if the price decline persists for a long time.  I doubt that the Federal Reserve would permit this, since their Chairman is a scholar on the Great Depression and is fully aware of the danger its poses.

Many economists are predicting an end to the recession at some point after mid 2009.  Some see a recovery later, even as late as the last quarter of next year.  What we are experiencing is without question a serious downturn, and there is little about it that we can like.  All we can do is to enjoy the drop in prices while it lasts, because it won’t last, if my reading of the economy is correct.

Leading indicators, a compilation of 10 individual statistics that point to the next three to six months, was bad for November.  Published by the Conference Board in New York, the chart below has the details.

The index has decreased 2.8 percent in the six months through November, the worst drop since 1991, when the economy was in a recession.

Drops in building permits and share prices, and increases in unemployment claims, led the index lower.

A report from Hong Kong states that the yuan is set to fall for about the next six months.  The Chinese monetary authorities have signaled they will allow the fall by small amounts in order to make Chinese exports more attractive to foreigners.  The China economy is heavily dependent on exports, and a strong yuan discourages sales to foreigners by making them more expensive.

China has been criticized by American and European governments last year for purposely undervaluing the yuan in order to support Chinese goods over those in the western nations.  In response to this criticism the yuan was allowed to rise for some of last year and into 2008.  But, as the chart below shows the last six months the yuan  has fallen in dollar terms, as reflected by the Wisdom Tree Chinese Yuan Fund (CYB). 

The reason they are allowing a slight fall in price now is because of the looming recession in the west which is contributing to reduced growth of China’s export industries.  There have been significant plant closings and cutbacks in the region of China that hosts most of the export industry.  This has led to fear of political instability. 

Chinese authorities are working hard on their own stimulus package to bolster domestic income by government spending on infrastructure projects, and lowering interest rates. 

Allowing the yuan to fall is in line with their other efforts to cushion the drop.  Their daily limit of .5% drop or rise in dollars has been reached a couple of times, but it is expected to be honored over the period.  It will simply be allowed to drop a little at a time, in keeping with the Chinese way of gradualism.

According to an article from Market Watch, Sebastien Barbe, senior economist for Asia, Calyon Credit Agricole, in Hong Kong has spoken on the issue, saying that the Chinese monetary authorities do not want the yuan to decline so much that it would ignite capital out-flows, but they do want some relief from falling exports. “From my point of view stability means no big fluctuations, it does not mean absolute stability of the currency versus the U.S. dollar,” Barbe said, adding the yuan could fall up to 6% against the dollar over the coming half year.

Because of the expected reduction in growth, export prices in China could drop some next year, giving them a little more leverage in keeping their export factories churning out products.

The yuan looks to be more of a prospect for short selling than holding a long position, at least until about midyear of 2009.  At that point, the consequences will be analyzed and a new policy formulated for the balance of the year.

The bursting of the real estate bubble is no longer news.  We can watch it unfold before our very eyes, as if we were watching some distant star explode a billion light years away.  The three pictures shown below show a snap shot of the real estate explosion and subsequent implosion.

The first chart shows Washington DC housing prices from 2001 through part of 2008.  The dates are fixed on all charts.  Washington DC was chosen because of its similarities to the national average.  You can see the darker blue bars, which represent the national average, are fairly close to Washington D.C.’s figures. 

Overall, the nation’s capital had a rather mild expansion and an equally mild crash.  Prices were up about 25% at the peak in early 2005, and down less than 20% in the middle of this year.

All charts from the NY Times

A more pronounced bubble is seen in the Los Angeles chart, below.  LA prices rose over 30% at their peak (in mid 2004), and have plunged closer to 30% since.

The champion of the bursting bubble, however, is Las Vegas.  This is the smallest market to be affected, so larger price swings would be expected.  We are not disappointed!  Their peak was up over 50%, close to the same time as LA, but much higher in percentage.  The fall is equally dramatic, reaching over 30% by mid 2008.

The end of the plunge of prices is not in sight, but you can see from the shape of the bar charts that the pace of the drop is showing a slowdown.  Charts do not control the real events, however, so one cannot say that the worst is over.  Prices could unexpectedly begin falling even faster than they are now.

There is something of a consensus among real estate specialists that prices will probably continue falling through most of 2009.  There are some who feel prices will continue falling well into 2010.

The importance of the turnaround cannot be overstated.  Our entire economy is suffering a similar decline, and until house prices stabilize, it will difficult for the entire economy to begin a recovery.

For a more detailed analysis of the current economic crisis, see my most recent article on Seeking Alpha.

The American economy lost 533,000 jobs in November, the most in 34 years.  The unemployment rate shot up to 6.7 percent, the highest in 15 years.  The last time that job losses in a single month were this bad or worse was in December, 1974.

The chart below provides a picture of how the recession has deepened throughout the year.

source: Bureau of Labor Statistics

If anyone had doubts about the severity of the recession that began at this time last year, there are none left.  The current slowdown points to a more bad news for the United States and the rest of the world as the continuing economic crisis searches for a bottom that appears to be far lower yet.

The next graph displays the job losses since June, 2007:

Almost no sector in the economy was spared.  Cutbacks hit factories, often the highest paying jobs, construction companies, financial firms, retailers, leisure and hospitality, and others. Government and health services were two of the few who did not post job losses.

The forecast for losses in November had been 320,000, so economists were shown to have missed the mark by more than 66%, a sure sign that the severity of the recession far exceeded general expectations.

Since the start of the recession last December, the economy has lost 1.9 million jobs, and the number of unemployed people has increased by 2.7 million — to 10.3 million now out of work.

Some analysts predict 3 million more jobs will be lost between now and the spring of 2010 — and that the once-humming U.S. economy could stagger backward at a shocking 6 percent rate for the current three-month quarter.

Job losses in September and October also turned out to be much worse than originally estimated. Employers cut 403,000 jobs in September, versus 284,000 previously estimated. Another 320,000 were chopped in October, compared with an initial estimate of 240,000.

To make matter even worse, as if we needed more bad news, this report from Economix states it clearly:

“If you take a broader measure — one that tries to account for them [discouraged workers] — you see a darker picture of the labor market. The share of all men ages 16 and over who are working is now at its lowest level since the government began keeping statistics in the 1940s. The share of women with jobs has fallen almost two percentage points from the peak it reached in 2000; at no other point in the past 50 years has the share of employed women has fallen so much from its peak.”

The recession is going to be the Grinch who stole Christmas, deepening as the holiday season nears.  With high unemployment, gift giving is likely to be reduced by many consumers.

My fear of unemployment as high as 10% was strengthened by today’s news.  A bottom for this recession is not in sight.

Speaking at the Clinton Global Initiative conference in Hong Kong, the chairman of China’s sovereign wealth fund , Mr. Lou Jiwei, said on Wednesday that China had no plans for further investments in Western financial institutions. “Right now we do not have the courage to invest in financial institutions because we do not know what problems they may have,”

The sovereign wealth fund had invested heavily in Barclays and Morgan Stanley, only to see the value of its investments plummet as the American and UK financial sector crashed. 

Mr. Lou also emphasized that China will be looking to shore up its own economy, targeting a $500+ billion spending program on new roads and other infrastructure projects that are badly needed there.  He said that the best way China could help the world economy would be to keep its own economy healthy.  This will counter any hope western banks and brokers had that China will use its almost $2 trillion in foreign currency reserves to help them raise badly needed capital.

China is also getting edgy about the slowing purchases from America.  This has led to large-scale layoffs at export-oriented factories in China, particularly in the Pearl River delta region near Hong Kong. Mr. Lou blamed a shortage of letters of credit from American banks, which he described as making it hard for American importers to obtain the money they need to buy Chinese goods even when they have ready buyers.

The recession in the West and in other emerging markets, whether in Asia, Africa, Latin America or Eastern Europe, will bolster the importance of China in the world’s economies.  All of Asia has been on the ascendency of late, and the current economic crisis will only speed up that process.  India, too, for example, has been experiencing high growth, and it looks to continue growing its economy, although at a slower pace than the last decade.

Mr. Lou did not mention China’s role in supporting the IMF with some of its huge foreign currency reserves.  At the next meeting of the G-20 in London, set for April, the issue will probably come up again, as many of the emerging market currencies need temporary support to prevent them from causing longer-term harm to the world economy.  With unstable exchange rates, neither buyers nor sellers can accurately predict product prices.  This disrupts the supply chain for everyone, and world trade volume is suffering.  But, for China to lend a hand in the currency stabilization effort, they have a right to insist on a better representation in the IMF.  For now, both China and India account for less than 5% of IMF voting.  This issue will have to be addressed before any progress could be expected on the currency stabilization front.

China is looking after China, right now.  And it probably is the best way for them to proceed.  They must keep their economy growing if they want political stability, so they must substitute some domestic spending to replace the falling exports that are causing serious cutbacks in their export-oriented factories.

China is already the world’s fourth largest economy, just behind Germany.  I look for it to pass Germany in 2009 or 2010.  The German economy is predicted to shrink in 2009, while China looks for a 5-6% growth.  It will be a major challenge for the new Obama administration to find the right tone for dealing with this emerging giant.

There is no good news today for the world’s economy, including America. In the United States, the monthly survey of business by The Institute for Supply Management showed that manufacturing activity fell to 36.2 from October’s 38.9. A figure below 50 indicates the sector is contracting. The Associated Press reports: “The November reading is the lowest since May 1982. . ., when the economy was in the midst of a painful recession. Economists said the report indicates that the economy is likely in a steep recession and times will remain tough for manufacturing companies in the coming months.”

This kind of drop in manufacturing is also shown in American automobile sales, which have put the three domestic automobile manufacturers at the doorway of bankruptcy. Of course, a slowdown of the auto industry also spills over into steel and many other members of the manufacturing sector.

Below is a video presentation by Mark Vitner on Bloomberg TV about the U.S. ISM index

Video Commentary

Construction spending, which also is a big buyer of building materials and other manufactured products also fell 1.2% in October.

Shifting our view from America to the rest of the world, the news is as bad or even worse. For car sales, alone, here are some of the monthly or year over year reports:

Italy’s Fiat reports a 20% drop in sales in November.

Spain’s auto industry reports a 50% fall in the last seven months.

France’s auto sales are down 14% year over year.

Japan is down 18.2% for the same period.

Sweden is down 36% in November.

Other international manufacturing data reported through Bloomberg are equally discouraging:

• Manufacturing in the 15 nations sharing the euro contracted by the most on record in November. A purchasing managers’ index dropped to 35.6 from 41.1 in October, remaining below the expansion threshold for a sixth month. That’s the lowest since Markit Economics began the poll in 1998.
• Manufacturing in China, the fastest- growing major economy, fell by the most on record in November, the China Federation of Logistics and Purchasing reported today. Its purchasing managers’ index fell to a seasonally adjusted 38.8 from 44.6 in October.
• The yuan fell the most since a fixed exchange rate ended in 2005, sliding 0.7 percent to close at 6.8848 per dollar. Economists at Citigroup Inc. said “more immediate policy help” was now needed on top of last month’s $586 billion stimulus package and biggest interest-rate cut in 11 years.
• In Russia, VTB Bank Europe said its measure of purchasing managers fell for a fourth month in November to 39.8, below the level recorded in 1998 when the government devalued the ruble and defaulted on $40 billion of debt.
• Indexes for Poland, Hungary, Sweden and the Czech Republic also showed some of the steepest-ever declines as recession struck their main export markets. South African manufacturing shrank at the fastest pace in at least nine years, pushing Investec Asset Management’s Purchasing Managers Index to 39.5 last month from 46.2 in October.

Here we have something new in the making: the first truly world economic recession in the memory of most people alive today. There was a similar occurrence in the 1930s, but that is not a memory for most people.

What is even newer is the fact that all the economies mentioned, and many others not mentioned, are embarking on an almost coordinate attempt to stimulate their economies by the two economic policies available to nations today: monetary policy of lowering interest rates (EEC, U.K., America, China, to name a few) and a large fiscal stimulus program of massive deficit spending to shore up consumer welfare and build infrastructure.

The G-20 meeting in Washington last month provided the first hint of a coordinated approach to the problem. (See my Seeking Alpha article on this meeting here.)

To my knowledge, there has never been such an approach, and this constitutes the good news. Economic modeling suggest that a coordinated approach to fiscal stimulus is more effective than individual country attempts. If each country engages in its own fiscal stimulus, then it will be effective, generally, but some of the effectiveness will be lost to exports. But, if all the trading partners engage at the same time, the “leakage” is offset. By the second half of 2009 we will know if this approach works or not.

For an up-date on the depth of the recession in the U.S., see: 34-Year High Job Loss

The OECD has released its estimates for growth in the major economies for 2009.  Robust growth is seen in China and India.  Less, but still good growth for Indonesia, while Russia, Brazil, and South Africa are less than robust, but still growing.  Australia and Turkey are growing, but even less than the others.

For most of Europe, the United States and New Zealand, it is recession.  Mexico, Spain and Scandinavia are expected to produce near zero growth.  Iceland, the tiny dark blue dot in the north Atlantic, is projected to have a -9.335% drop in GDP.

OECD Visualization of World Growth for 2009

The table below details the specifics of GDP projections for many countries.

Almost all of the largest economies and some of the smaller  ones, have growth stimulus packages in place or on the table.  This will help keep the recessions from going deeper in the red, especially if they all are implemented at roughly the same time.

If one country increases government spending is a stimulus program, then there will be an expected positive addition to GDP.  But, some of that growth will be exported to their trading partners.  For example, if the U.S. were to enact a stimulus program by itself, it would lose some of the growth to imports from Mexico, Canada and China.  But, if all four countries enact similar programs at the same time, there will be an even larger expansion in all countries.  The mathematics of this are somewhat complex, and they lack definitive precision.  But, the modeling that is used by economists are well tested over decades of experience.  Mr. Obama’s economic team will be using this type of modeling in order to determine how large a stimulus is needed to grow our economy out of the recession.

One variable not tested in this type of modeling, however, is how the credit markets will accommodate simultaneous borrowing by many countries at the same time.  Is there enough world demand for debt to buy all the bonds that would be issued with the huge influx that would come from simultaneous borrowing?  I don’t know the answer to this question, but it does seem to me to point to some limits on the ability of the world economy to engage in large-scale borrowing at the same time.

On the positive side, China is able to buy $2 trillion itself, out of current reserves.  If they stay positive in their trade balance, then they could buy even greater quantities next year.  There is still plenty of international credit available, even if the large banks are dried up for now.

Watch a well informed discussion of the new stimulus plan President-Elect Obama offered in his weekly radio (and YouTube) address.  George Stephanopoulos leads the discussion between George Will, Arianna Huffington, David Brooks and Robert Kuttner on the merits of the plan.

This is well worth the time if you want to see a well informed and civil discussion.  Every point of view is represented and debated–liberal, progressive and conservative.

Discussion of President Obama’s Proposal on Stimulus Spending

In another interview, Paul Krugman, 2008 Nobel Prize winner in economics,  noted the need for a massive spending and employment program to move the economy away from the entrance to a major depression.  We are not there, he insisted, but we could get there without an immediate implementation of a plan to get people employed and money flowing again.

Mr. Krugman also emphasized that there are two crises happening at the same time: a financial crisis on Wall Street, where the American Banking system is breaking down, and another crisis on Main Street where breadwinners are losing their jobs, can’t get loans and can’t make their house payments.  So far, the Bush Administration has addressed only the Wall Street side of the problem.  Mr. Obama’s plan goes a long way to begin a remedy of the second.  Mr. Krugman sees possibly another one and a half million additional jobs lost before Mr. Obama takes office.

Late breaking news on Sunday said that the Democrats in Congress would have a $700 billion stimulus plan ready for Mr. Obama’s signature on the day he is sworn into office.