Slower Growth, Financial Turbulence, Persisting Job Stress of 27 Million and Failures of Economic Policy

Slower Growth, Financial Turbulence, Persisting Job Stress of 27 Million and Failures of Economic Policy
Carlos M. Pelaez

The objective of this post is to relate (I) slowing economic growth to (II) financial turbulence, (III) job stress and (IV) failures of economic policy. Economic indicators are analyzed in (V) and interest rates in (VI) while (VII) concludes.
I Economic Growth. The world economy is growing in 2010 and is likely to grow in 2011. However, growth is uneven among regions. The July update of the World Economic Outlook (WEO) of the IMF projects continuing growth of the world economy of 4.6 percent in 2010 and 4.3 percent in 2011 (http://www.imf.org/external/pubs/ft/weo/2010/update/02/index.htm#tbl1 ). The world economy lost 0.6 percent of output in 2009 after growing by 3.0 percent in 2008. The outlook for the “advanced economies” is less promising with growth of 2.6 percent in 2010 and 2.4 percent in 2011 after decline of 3.2 percent in 2009 and growth of only 0.5 percent in 2008. The growth impulse in the projections originates in emerging and developing economies that grow by 6.8 percent in 2010 and 6.4 percent in 2011 after growing by 2.5 percent in 2009 and 6.1 percent in 2008. The sharpest decline in output in 2009 was -7.9 percent in Russia and the best performance was growth in China by 9.1 percent. The growth prospects for the largest economies are not attractive: US 3.3 percent in 2010 and 2.9 percent in 2011, euro area 1.0 percent in 2009 and 1.3 percent in 2011 and Japan 2.4 percent in 2010 and 1.8 percent in 2011. The contraction of output was -2.4 percent in the US in 2009, -4.1 percent in the euro area in 2009 and Japan -1.2 percent in 2008 followed by -5.2 percent in 2009. Comparisons of the global recession with the Great Depression are seriously misleading. Comprehensive review of the vast literature on the Great Depression reveals a contraction of output and employment that was immeasurably stronger than the world contraction in 2008-2009 with high unemployment until World War II (Pelaez and Pelaez, Regulation of Banks and Finance, 197-217). The decline in real or price adjusted GDP in 1930-1933 accumulated to 26.7 percent and 45.5 percent in current dollars or without adjusting by price changes (Pelaez and Pelaez, Financial Regulation after the Global Recession, 151). The magnitude of the recession of 2008-2009 should be increased by the decline of the rate of economic growth from trend, which would add about 3 percent of lost GDP to the US. The sum of actual contraction and growth below trend would result in GDP loss in the US of about 6 percent, which is substantial but minute, compared to the depth and length of the Great Depression. Another important calculation of the IMF WEO Apr 2010 update is the contraction of world trade: growth of only 2.8 percent in 2008, -12.9 percent in 2009 and recovery by 9.0 percent in 2010 and 6.3 percent in 2011. The IMF obtains its information through research and continuing consultations with its member countries, constituting an important global public good (Pelaez and Pelaez, International Financial Architecture, Government Intervention in Globalization, 145-50, Globalization and the State, Vol. I, 129-31, Globalization and the State, Vol. II, 46-8, 114-25).
II Financial Turbulence. An important projection of the IMF’s WEO of Apr 2010 is the increase in the net debt of the US from 47.2 percent in 2008 to 85.5 percent in 2015 and of the gross debt from 70.6 percent of GDP in 2008 to 109.7 percent of GDP in 2015 (http://www.imf.org/external/pubs/ft/weo/2010/01/pdf/text.pdf 169). The July WEO update depicts revealingly the current crossroad: “recent turbulence in financial markets—reflecting a drop in confidence about fiscal sustainability, policy responses, and future growth prospects—has cast a cloud over the outlook. Crucially, fiscal sustainability issues in advanced economies came to the fore during May.” High unemployment and weak household and financial balance sheets constrain private spending required for strong demand that would drive faster economic growth. The IMF WEO July update argues that financial turbulence can affect the overall economy through various channels such as reduction of credit by uncertainty on risk exposures of banks and higher funding costs. Private consumption and investment could be less dynamic because of declining consumer and business confidence. The IMF still finds that the recovery of the global economy will continue even with more financial turbulence.
Equity markets improved substantially in the past week but continue to be much lower than their recent peaks (http://online.wsj.com/mdc/page/marketsdata.html ). The percentage performance of major US indices was: DJIA -9.0 from the recent peak on Apr 26 to Jul 9 and 5.3 in the week; S&P 500 -11.4 from the recent peak on Apr 23 and 5.4 in the week; and NYSE Financial -14.2 since Apr 15 and 7.7 in the week. The percentage performance of major world stock markets from Apr 15 to Jul 9 was: Dow Global -14.0 and 5.4 in the week; Dow Asia Pacific TSM -9.2 and 3.7 in the week; Shanghai -21.9 and 3.7 percent in the week; and STOXX Europe 50 -10.4 and 5.8 in the week. The euro strengthened, trading at $1.2642/EUR on Jul 9. The dollar has gained 19.7 percent relative to the euro since the recent trough on Nov 25, 2009, but lost 0.6 percent in the week. The DJ UBS commodity index fell 12.5 percent since the recent peak on Jan 6 and gained 2.4 percent in the week. The beginning of reports of second quarter corporate earnings on Monday is awaited with optimism by investors. Earnings reports are backward looking information while investment in financial variables is forward looking. The weighing in investment decisions of the probable impact of some deceleration of growth relative to strong earnings reports may have strong influence on financial turbulence.
Indicators of financial risk continue to reflect financial turbulence. The 10-year Treasury traded at 3.057 percent on Jul 7 because of the use of Treasuries and high quality mortgage-based securities and corporate debt as safe haven from financial risk. Inflows into money market funds increased to $33.5 billion in the week of Jul 9, the largest inflows in 18 months since Jan 2009 when inflows were $37.7 billion (http://www.ft.com/cms/s/0/b0877070-8b84-11df-ab4d-00144feab49a.html ). Commercial real-estate loans are still a source of difficulties for US banks. The research firm Foresight Analytics is quoted by the Wall Street Journal as estimating $176 billion of troubled commercial real estate loans. Approximately two-thirds of commercial real-estate loans that mature until 2014 are underwater with property prices below loan values; the delinquency rate of commercial-property loans held by banks rose to 9.1 percent in the first quarter in contrast with 7 percent a year earlier and 1.5 percent in the first quarter of 2007 (http://professional.wsj.com/article/SB10001424052748704764404575286882690834088.html?mod=wsjproe_hps_LEFTWhatsNews ). The three-month euro interbank rate in London increased to 0.76 percent, which is the highest level in 10 months. The euro LIBOR-OIS spread increased to 19.3 basis points while the three-month dollar LIBOR fell slightly to 0.5277 percent (http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=ayFxN3BLEVeE ). There is still uncertainty as to what the stress tests of European banks will reveal. The success of US stress tests of banks was followed by a 36 percent increase in their stock prices. The S&P 500 financial index declined by 6 percent in 2010, much lower than the decline by 14 percent of Bloomberg’s index of Europe Banks and Financial Services. The 20 largest banks in Europe trade at a discount of 10 percent relative to book value but the 20 largest US banks trade at a premium of 10 percent (http://noir.bloomberg.com/apps/news?pid=20601109&sid=abl8IFKnuuaU&pos=10 ).
III Job Stress. The US economy is lagging others in job recovery. An analysis of 11 countries by the Wall Street Journal finds a positive association between strong job recovery and moderate debts and strong banking systems (http://professional.wsj.com/article/SB10001424052748704799604575357031890309998.html?mod=wsjproe_hps_LEFTWhatsNews ). Employment has increased by 4.5 percent in Brazil and 6.8 percent in Chile since Dec 2007. Interregional trade in commodities with Asian countries and relatively unharmed financial system has permitted Australia to increase employment by 3.7 percent. In contrast, the WSJ research finds that employment in the US had declined in Jun by 4.8 percent relative to Dec 2007. The US consumer is burdened by household debts of 122 percent of disposable income, which is still below the peak of 131 percent, but still at a level exerting pressure on further spending. Another important example is Japan with government debt above 200 percent of GDP and employment down 3.3 percent from Dec 2007. There were 27 million people in job stress in the US in Jun, composed of: 14.6 million unemployed (of whom long-term unemployed of 6.8 million or 45.5 percent who have been unemployed more than 27 weeks), 8.6 million working part-time because they could not find a better job, 2.6 million marginally attached to the labor force (who wanted and were available for work and had searched for work in the prior 12 months) and 1.2 million discouraged workers (who believe there is no job for them or had not searched for work in the prior four weeks) (http://www.bls.gov/news.release/pdf/empsit.pdf ). The combination of high household debt and weak financial system is the result of four economic policies that were the root cause of the credit/dollar crisis and global recession ((Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). First, the Fed lowered the fed funds rate to 1 percent in 2003 and left it at that level until 2004 with the forward guidance that it would maintain it at that level until required in fear of deflation that never existed (http://www.federalreserve.gov/boarddocs/SPEECHES/2002/20021121/ ). Households and other economic agents were induced to take high debts, consuming and financing almost everything with short-dated funds. There would never be risks again because the Fed assured a “great moderation,” or permanent prosperity with fewer, milder recessions and perennially low inflation. Fed policy distorted the calculation of risks, which were made by policy to look nonexistent, and rewards, which were illusorily made to look unbounded. The policy induced excessive leverage and risks in financing, discouraging liquidity while eroding soundness in credit evaluation. Adjustable rate mortgages (ARMS) looked attractive because the low short-dated interest rate would be maintained forever by Fed policy. The near zero interest rate caused the intended boom of the economy. The Fed then decided to increase the fed funds rate by 25 basis points (bps) at every one of 17 consecutive meetings of the Federal Open Market Committee (FOMC) from 1 percent in Jun 2004 to 5.25 percent in Jun 2006, eroding the illusion of a Fed-guaranteed floor on house prices that precipitated the real estate debacle. Second, the Fed has experimented with policies that can bring down long-term interest rates to the level of fed funds rates. Treasury suspended the auctions of 30-year Treasuries from 2001 to 2005 to boost investment and credit by lower yields on asset-backed securities or securitization of loans. High-quality mortgage-backed securities (MBS) began to be used in matching assets with long-term obligations such as pensions. The increase in demand for MBS caused an increase in their prices, which is equivalent to lowering their yields. The first wave of refinancing of mortgages injected more income in households than tax rebates because of lower monthly payments in house loans. New acquisitions of homes and home-equity loans further fueled the housing, consumption and debt boom. Third, the US has maintained a yearly housing subsidy of $221 billion per year, which has contributed significantly to a surplus of housing that eventually depressed prices. Fourth, Fannie Mae and Freddie Mac purchased or guaranteed $1.6 trillion of nonprime mortgages, giving the seal of government quality to unsound house loans (Edward Pinto, cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 47, Regulation of Banks and Finance, 219-20).
IV Failures of Economic Policy. The response of the government to the credit/dollar crisis was massive stimulus. Fiscal policy consisted of the $787 billion American Recovery and Reinvestment Act (ARRA) signed on Feb 17, 2009, as “an unprecedented effort to jumpstart our economy, save and create millions of jobs and put a down payment on addressing long-neglected challenges so that our country can thrive in the 21st century” (http://www.whitehouse.gov/recovery/about ). The government increased expenditures sharply to 25 percent of GDP while tax revenue declined from 18.5 percent of GDP in 2007 to 14.8 percent of GDP in 2009, remaining at nearly the same level in 2010 ((http://professional.wsj.com/article/SB10001424052748703426004575338991852947182.html ). Monetary policy consisted of a zero fed funds rate as of Dec 2008, multiple facilities of financing and the acquisition by the Fed of a portfolio of long-term Treasuries, agency debt and MBS to lower long-term rates that has resulted in a Fed balance sheet of $2.3 trillion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 224-7). The Fed is in a policy corner of unwinding the balance sheet and increasing interest rates of relatively monumental proportions relative to the crossroad of Jun 2004 when it increased interest rates over a long period in small increments. The combination of the fiscal and monetary stimulus has created the expectation of taxation and increases in interest rates that may restrict investment and hiring. The new jobs strategy is export-led growth, creating two million jobs by doubling exports. The strategy is allegedly already on track by government data showing growth of exports of 17 percent in the first four months of 2010 relative to depressed levels in 2009 (http://professional.wsj.com/article/SB10001424052748703636404575352731258196298.html?mod=wsjproe_hps_MIDDLEForthNews ). US exports are merely following the recovery of world trade but not because of the US declared intention to revive trade agreements with South Korea, Colombia and Panama, which face difficult approval in Congress and may not boost exports as desired. The fact is that there is a current “hold” on optimism on the US economy (http://www.ft.com/cms/s/0/83c978de-8b8a-11df-ab4d-00144feab49a.html ). The threat of taxation and rising interest rates is combining with complex legislative restructurings for alleged long-term benefits and deeply intrusive, widespread regulatory shocks to discourage investment and job creation. The type of change and the threat of more inopportune change are asphyxiating private investment and job creation in the US economy. Government spending even financed by taxes such as not to create deficits, or tax to spend, “crowds out,” or reduces the private investment that would have occurred without the fiscal expansion of the government (Olivier Blanchard and Roberto Perotti, Quarterly Journal of Economics 117 (4), 1363). The replacement of job-creating private investment by fiscal government expansion and the discouragement of small and medium business investment by taxation, interest rates and other costs of doing business is a major cause of the job stress of 27 million people.
V Economic Indicators. The US economy continues to expand, perhaps with slight deceleration, but growth is insufficient to create required employment that would alleviate the job stress of 27 million people. The Institute of Supply Management (ISM) index of the non-manufacturing sector finds that economic activity rose in Jun for the sixth consecutive month but the index fell from 55.4 in May to 53.8 in Jun, showing a slightly lower rate of growth. The employment index fell to 49.7 percent, showing mild contraction or stability (http://www.ism.ws/ISMReport/NonMfgROB.cfm ). Consumer credit fell by $9.1 billion in May relative to Apr and is $107.5 billion below the level in 2007 or a decline of 4.3 percent. Revolving credit dropped by $7.4 billion in May relative to Apr and is $112.1 billion below the level in 2007 or a decline of 11.9 percent (http://www.federalreserve.gov/releases/g19/Current/ ). Consumers may not be demanding as much credit as before because of uncertainty about employment and the economy. Tighter consumer credit terms and higher rates have occurred already because of the CARD (Credit Card Accountability, Responsibility and Disclosure) Act of May 2009 and even worst conditions are likely under the consumer protection agency of the Dodd-Frank bill. Sales of merchant wholesalers fell 0.3 percent in May relative to April but were still higher by 15.1 percent relative to May 2009. While sales of durable goods grew by 0.5 percent in May relative to Apr, sales of nondurable goods fell by 1.0 percent. Inventories rose by 0.5 percent (http://www2.census.gov/wholesale/pdf/mwts/currentwhl.pdf ). Seasonally-adjusted initial claims for unemployment insurance fell by 21,000 to 454,000 in the week ending on Jul 3 relative to the prior week. The four-week moving average fell by 1250 to 466,000 (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). Claims are still at a high level relative to around 350,000 in 2007.
VI Interest Rates. The US yield curve is stationary with the peculiar shape of a long segment close to zero percent, rising mildly to 0.63 percent for the 2-year Treasury and then rising more sharply with 1.84 percent for the 5-year Treasury, 3.06 percent for the 10 year and 4.04 percent for the 30 year. The 10-year Treasury yield rose to 3.06 percent from 2.98 percent a week ago and declined from 3.22 percent a month ago (http://markets.ft.com/markets/bonds.asp ). The unwinding of the $2.3 trillion Fed balance sheet with this yield curve and the federal debt in an unsustainable path may not be harmless to the overall economy. The 10-year German government bond traded at 2.64 percent on Jun 9 with a negative spread relative to the 10-year Treasury of 42 bps.
VII Conclusion. There is complex interrelation of slowing economic growth, financial turbulence, job stress and failures of economic policy. Policies stimulating investment in the private sector are more likely to generate new employment that will alleviate the job stress of 27 million people. Crises are inopportune events for advancing legislative restructurings and regulatory shocks shifting decisions from business to government because of crowding out of private investment and exacerbating uncertainty in business decisions and hiring. Policy is asphyxiating job creation. (Go to http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )