Flattening Economic Growth and Weakening Job Creation

 

Flattening Growth and Weakening Job Creation

Carlos M. Pelaez

The post documents in (I) flattening economic growth and in (II) weakening job creation. The causes of flattening growth/employment creation are analyzed in (III). Financial turbulence is discussed in (IV). Interest rates are covered in (V) and (VI) concludes. If you have difficulty in viewing the tables and illustrations go to: http://cmpassocregulationblog.blogspot.com/

I Flattening Growth. Short-term economic indicators continue to suggest deceleration of economic growth. Real estate and industry are considered in this section and employment in the following section. First, an important symptom of flattening growth is the continuing stress in construction and real estate markets, which has been erroneously blamed solely on reckless lending by financial institutions to camouflage the major role of government policy and justify draconian regulation. In Jan 2006, housing starts in the US were at an annual seasonally-adjusted (SA) rate of 2265 thousand (http://www.census.gov/const/newresconst_200701.pdf ). In Jul 2010, housing starts were at an annual SA rate of 546 thousand, higher by 1.7 percent above the Jun revised estimate of 537 thousand but 7.0 percent below the Jul 2009 rate of 587 thousand and 75.9 percent below the level of 2265 thousand in Jan 2006. Building permits for privately-owned housing units were at an annual SA rate of 565 thousand, which is 3.1 percent below the revised Jun rate of 583 thousand and 3.7 percent below the Jul 2009 estimate of 587 thousand (http://www.census.gov/const/newresconst.pdf ). The causes of the housing debacle began in the 1990s (Edward J. Pinto, The Future of Housing Finance, WSJ, Aug 17, 09 http://professional.wsj.com/article/SB10001424052748704407804575425231311880538.html ). The GSE Act of 1992 and HUD’s National Homeownership Strategy led to lax standards in national mortgage underwriting. While in 1990 only one in 200 government-insured loans to buy houses had down payments less than or equal to 3 percent, in 2006 about 30 percent of all home buyers had no down payments. Fannie and Freddie required only $900 of capital in backing a $200,000 mortgage (Ibid). An important cause of the real estate collapse and the recession was a yearly housing subsidy estimated in 2006 at $221 billion, composed of $37.9 billion in government spending for low-income housing, $156.5 billion in federal tax housing expenditures and $26.7 billion in credit subsidies for Fannie, Freddie and the Veteran’s administration (Dwight Jaffee and John Quigley cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 42-8, Regulation of Banks and Finance, 79-80). The housing subsidy was magnified by monetary policy that suspended the auctions of 30-year Treasuries to lower mortgage rates and fixed fed funds rates of 1 percent in 2003-2004 that encouraged financing of everything with short-dated funds, including adjustable rate mortgages (ARMS) to NINJA (no income, no job and no assets) borrowers (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). Housing and Fed monetary policies wrote an illusory, deceiving put option on house prices paid by taxpayers: if house prices collapsed below the mortgage debt, as they did, because of over construction, tax-payer funds would be used for bailing out Fannie, Freddie, mortgage banks, NINJA debtors and whatever failed. Three avenues for change of Fannie and Freddie would be: (1) return to shareholders of the retained portfolio of assets and relocation of Fannie and Freddie to another government agency; (2) maintenance of the Fannie and Freddie model but with stronger regulation to prevent unsound balance sheets and systemic risk; and (3) issue of covered bonds by the originating financial entities to promote sound mortgage origination (Dwight Jaffee cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 47-8). A minimum agenda of reform would be to eliminate the subsidy on housing and to explicitly incorporate any guarantees in the government budget instead of hiding them in the balance sheets of Fannie and Freddie. Unfortunately, the reform is being directed toward three avenues: (1) federal guarantees of a substantial proportion of mortgage-backed securities issued to finance US home mortgages; (2) taxes on these securities to finance low-income housing; and (3) requirements on the issuers of complying with mandates of affordable housing (Edward Pinto, op.cit.). Policymakers with professed aversion to derivatives have reinvented a new derivative on housing. The guarantees and “affordable” housing subsidies of the new system recreate a put option issued on the price of houses with the guarantee of tax payers’ money. That is, when housing prices collapse again after excessive construction driven by these new proposed subsidies, Fannie, Freddie, careless mortgage bankers, NINJA debtors and guaranteed mortgages will be bailed out again with taxpayer funds. Fannie and Freddie are in a new class of “too politically important to fail.”

Second, the deceleration of industry is less clear because two regional surveys by the New York and Philadelphia Federal Reserve Banks suggest deceleration into Aug and beyond while the national Fed survey finds higher growth in Jul. Industry fell before the beginning date of the recession by the NBER and recovered ahead of the economy, providing the highest optimism for sustained growth. The index of general business conditions of the Empire State Manufacturing Survey of the Fed of New York rose two points from Jul to reach 7.1 in Aug. The general business index suggests improvement “at a very modest pace.” The forward information is evidently negative and caught the attention of financial markets: “the future general business conditions index fell 6 points to 35.7, a reading well below the levels observed earlier this year. The future new orders index dipped 3 points to 31.4, and the future shipments index retreated 6 points to 25.7” (http://www.newyorkfed.org/survey/empire/empiresurvey_overviewexpand.html ). The release of the report on industrial production and capacity utilization by the Fed brought relief that the recovery was continuing. Total industrial production in the US grew 1.0 percent in Jul after dropping 0.1 percent in Jun; manufacturing grew by 1.1 percent after falling 0.5 percent in Jun; the rate of capacity utilization for total industry reached 74.8 percent, higher by 5.7 percentage points relative to a year earlier but still 5.8 percentage points below the average for 1972 to 2009; and total industry was 7.7 percent higher in Jul than a year earlier but still at 93.0 percent of the average for 2007. Production of motor vehicles and parts grew 10 percent, but manufacturing excluding motor vehicles and parts rose by 0.6 percent (http://www.federalreserve.gov/releases/g17/Current/default.htm ). The Aug Business Outlook Survey of the Philadelphia Fed contributed to the impression of deceleration. The broad index of current activity fell from 5.1 in Jul to -7.7 in Aug, which is the first monthly decline since Jul 2009. The forward indicators may be revealing uncertainty with the new orders index falling to -7.1, the shipment index becoming negative at -4.5 and weak indexes for delivery times and unfilled orders (http://www.philadelphiafed.org/research-and-data/regional-economy/business-outlook-survey/2010/bos0810.pdf ).

II Weakening Job Creation. Initial jobless claims SA rose by 12,000 in the week of Aug 14 to reach 500,000 from the Aug 7 revised level of 488,000. This is a significant increase over the fluctuation around 450,000 in 2010. Initial claims SA reached 575,000 a year ago. The four-week moving average SA new claims grew by 8000 to reach 482,500 in the week of Aug 14 compared with the revised 474,500 a week earlier. Non-seasonally adjusted (NSA) initial claims actually fell by 22,644 from 424,500 in the week of Aug 7 to 401,856 in the week of Aug 14 (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). Economic growth is subpar in this expansion phase of the economy with resulting weakness in labor markets. The unemployment rate increased from 9.4 percent in Jul 2009 to 10.1 percent in Oct 2009, declining to 9.5 percent in Jul 2010 but the percentage of the adult noninstitutional (or civilian) population having a job declined steadily from 59.3 percent in Jul 2009 to 58.4 percent in Jul 2010 (http://www.bls.gov/web/empsit/cpseea3.pdf ). Many people willing and able to work are discouraged from seeking employment. There are 27 million people unemployed, working part-time because they do not find another occupation, marginally attached to the labor force or discouraged that there is no job for them.

III Causes of Flattening Growth/Employment Creation. US economic policy has consisted of a short-run strategy to revive the economy by stimulus and simultaneous structural change for alleged improvements in the long run. The short-run economic policy of the US has consisted of massive fiscal and monetary stimuli designed to drive growth and motivate job hiring. At the same time, policy has engaged in complex legislative restructuring of large segments of economic activity, draconian regulation and mandates. Growth is flattening and labor markets weakening because of the uncertainty of the impact of legislative restructurings on profits and business models and the fear of taxes and interest rate increases resulting from the stimulus. The fiscal stimulus of an effective $862 billion can be broken down into three categories: $296 billion in aid to states, unemployment and food stamps, $230 billion in infrastructure (of which $164 billion are unspent) and $336 billion in tax cuts, one-time payments and other finance provisions (http://online.wsj.com/public/resources/documents/stimulus0814.pdf ). From a long-term perspective, most of these projects have much lower present value of benefits less costs than those in the private sector from which the government obtained the funds by future taxation. Such a massive stimulus would have already driven economic activity and employment, creating doubts about the claims that the stimulus bill ARRA “has raised employment relative to what it otherwise would have been by between 2.5 and 3.6 million” and that “ARRA has raised the level of GDP as of the second quarter of 2010, relative to what it otherwise would have been by between 2.7 and 3.2 percent” (http://www.whitehouse.gov/files/documents/cea_4th_arra_report.pdf ). There are also doubts as to whether the monetary stimulus of the 0 to 0.25 percent rate on fed funds and the $2.3 trillion bloated Fed balance sheet (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ) have recovered the economy and saved or created jobs (see the analysis of monetary policy in Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-62, Regulation of Banks and Finance, 224-7). Flattening economic growth and weakening labor markets instead of V-shaped recovery and robust labor markets as in expansions after historical deep contractions appear to be a consequence of the uncertainty on business models created by the legislative restructurings, draconian regulation and mandates that have replaced private sector allocation with official allocation, creating uncertainty about the returns on investment and the costs of hiring. Table 1 shows another uncertainty in the form of a government deficit that has soared from 1.9 percent of GDP in 2006 to over 9 percent of GDP in 2009 and 2010. The forecast deficits keep on rising after every revision because of the uncertainty of future revenue depending on economic growth that is decelerating. There is doubt if the deficits will be again below one trillion dollars. The error was raising expenditures from 19.6 percent of GDP in 2007 to 24.7 percent of GDP in 2009 by an increase in expenditures of 18 percent while revenue fell 16.6 percent. Revenue fell to 14.8 percent of GDP in 2009 and 14.6 percent of GDP in 2010 because of the weak economy with poor prospects because of decelerating growth. Crises are not opportunities for spending away the future because of the costs of the current growth deceleration and weak employment in anticipation of major tax increases. Long-term government revenues in the US have remained historically below 20 percent of GDP so that the deficit and debt are in an expansion that may cause an adverse sudden stop of the economy in the future when taxes must be increased and expenditures contained. The unwinding of the Fed balance sheet by sale of $2 trillion long-term bonds and Treasuries may cause higher interest rates than required in an eventual upswing of the economy that could also contribute to flattening the growth curve.

Table 1, Government Revenues, Expenditures and Debt

	2006	2007	2008	2009	2010	2011	2012
$ Billions
Revenue	2406	2568	2523	2105	2143	2648	2953
Expend	2655	2728	2982	3518	3485	3714	3618
Deficit	-249	-160	-459	-1413	-1342	-1066	-665
Net Debt	4828	5035	5803	7545	9031	10007	10790
% GDP
Revenue	18.2	18.5	17.5	14.8	14.6	17.5	18.7
Expend	20.1	19.6	20.7	24.7	23.8	24.5	23
Deficit	-1.9	-1.2	-3.2	-9.9	-9.1	-7.0	-4.2
Net Debt	36.5	36.2	40.2	53	61.6	66.1	68.5

Source: http://www.whitehouse.gov/sites/default/files/omb/budget/fy2011/assets/hist.pdf http://www.cbo.gov/ftpdocs/117xx/doc11705/08-18-Update.pdf

The Basel III capital accord appears to take final shape as some definitions crystallized on Jul 26 (http://www.bis.org/press/p100726/annex.pdf ) following considerable negotiation (http://www.ft.com/cms/s/0/ab02375c-aafb-11df-9e6b-00144feabdc0.html ). Major definitional issues have been approved on three important components of the agreement before final calibration. First, the definition of Tier 1 capital may include “significant investments in the common shares of unconsolidated financial institutions,” mortgage servicing rights and deferred tax assets but banks must deduct from common equity for Tier 1 capital the value that exceeds the aggregate of these three items by 15 percent of the common equity component of Tier 1 capital. Second, calibration of the agreement will consider a Tier 1 leverage ratio of 3 percent with transition period until 2018. Third, the definition of the liquidity coverage ratio, or liquidity required to withstand a crisis of 30 days, will be defined and calibrated to minimize distortions of the system while penalizing imprudent liquidity practices. The critical difference between the Basel III process and the US Dodd-Frank bill of financial regulation is the competent care by the Basel Committee on Banking Supervision in crafting prudential regulation and supervision on the basis of technical principles that preserve the functions of financial intermediation required for growth and employment creation. The rushed Dodd-Frank bill will make US banks uncompetitive relative to international banks, restricting the volume of credit and increasing the costs of borrowing, preventing the V-shaped recovery required to attain full employment. The consequence of the Dodd-Frank bill is an increase in borrowing costs of every activity by business and households while the financial system continues to be vulnerable to crises.

IV Financial Turbulence. Financial turbulence is returning as a result of the doubts on the world economy and global financial markets. Table 2 provides a summary of turbulence in stocks, commodities, the dollar and Treasury yields. The columns provide the dates of the recent peaks and troughs of financial variables and the percentage change from recent peak to trough, peak to Aug 20 and change in the week ending on Aug 20. Equity indexes fell in major stock exchanges, except China and Asia Pacific, with the Global Dow losing 0.9 percent. European and American stocks were particularly affected. The dollar appreciated to $1.2705/euro, reversing the depreciation of earlier weeks. Commodity prices fell and oil trended toward $73/barrel. The 10-year Treasury collapsed to 2.616 percent partly because of the use of highly-rated fixed income as safe haven in the flight out of risk exposures; perhaps the expectation of further quantitative easing also caused decline in yields.

Table 2, Stocks, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	% Trough	% 8/20	Week 8/20
DJIA	26-Apr	2-Jul	-13.6	-8.8	-0.9
S&P 500	23-Apr	2-Jul	-16	-12	-0.7
NYSE Fin	15-Apr	2-Jul	-20.3	-16	-1.2
Dow Glob	15-Apr	2-Jul	-18.4	-13.2	-0.9
Asia	15-Apr	2-Jul	-12.5	-7.4	0.5
China	15-Apr	2-Jul	-24.7	-16.5	1.4
Europe STOXX	15-Apr	2-Jul	-15.3	-9.3	-1.8
Dollar	25-Nov	25-Jun	22.3	19.1	0.4
DJ USB Com	6-Jan	2-Jul	-14.5	-9.4	-1
10 Year T	5-Apr	20-Aug	3.986	2.616

Source: http://online.wsj.com/mdc/page/marketsdata.html

The US Treasury with redemption date on 08/20/2020 with coupon of 2.63 percent was quoted at a yield of 2.61 percent or price of 100.13 on Aug 20 (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-200810 ). The price of that bond for settlement on 8/23/2010 at a yield of 3.98 percent would be 88.959 or a decrease of price by 11.2 percent [88.959/100.13 -1]100. In practice, such a backup of yields would not occur but it could happen over time as the 10-year Treasury yield fell from 3.986 percent on Apr 5 to 2.61 percent on Aug 20, that is, in just 138 days. Unloading of duration and leverage in professional bond portfolios could accentuate price decreases, which may occur when the Fed gives the first sign of unloading its portfolio of two trillion dollars of long-term securities. Professor Jeremy Siegel, of the Wharton School, and Jeremy Schwartz, of Wisdom Tree, analyze the risks of capital losses of positions in Treasuries with high duration in a must-read opinion article for the Wall Street Journal (http://professional.wsj.com/article/SB10001424052748704407804575425384002846058.html ). An increase in yields of 10-year Treasuries from 2.8 percent to the 4 percent almost reached in Apr would cause a capital loss exceeding three times the current yield of 10-year Treasuries (Ibid). Such an increase could occur as Siegel and Schwartz point out because of acceleration of the rate of growth of the economy. They quote data from the Investment Company Institute that from Jan 2008 to Jun 2010 the outflows from equity funds totaled $232 billion while $559 billion flowed into bond funds. There may be another but similar avenue for a rise in stocks compared to decline of bonds. Companies are holding $3 trillion in cash (http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=aFzUwxN3LKsQ ). After all recessions and similar events, there is need for reorganizations in which companies change business models, selling entire divisions or lines of business to acquire others. The boom in takeovers at the turn of the 1990s was driven by the changes caused by the third industrial or technological revolution that created excess capacity by technological/organizational change, government policy and globalization; exit by the capital markets is value creating compared to alternative liquidation (Michael C. Jensen, The modern industrial revolution, exit and the failure of internal control systems, Journal of Finance 1993, cited in Pelaez and Pelaez, Globalization and the State Vol. I, 49-51, Government Intervention in Globalization, 46-7). Bloomberg estimates that $3.51 trillion of deals were announced in 2006 and $4.02 trillion in 2007 (http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=aFzUwxN3LKsQ ). The cash-rich position of companies suggests that they can leverage to take opportunities of changing or improving their business models in what is necessary reorganization in economies worldwide. The other catalyst of stock markets could be a shift away from the policy of legislative restructurings and regulation in a new reality created after November that more adequately balances the role of the private sector in economic allocation and job creation. The combination of new consolidation via capital markets and inflow of funds into equities and away from bonds could trigger the realization of capital losses in bond positions with long duration. An accelerating fiscal deficit and rising interest rates as the Fed realizes there is no more ammunition to buy trillions of dollars of government bonds could hurt bond investments long in duration with high leverage.

V Interest Rates. The US yield curve continues to trend down to 2.62 percent on Aug 20 from 2.69 percent a week earlier and 2.89 percent a month earlier. Much the same has occurred with the 10-year government bond of Germany that traded at the yield of 2.27 percent on Aug 20 for a negative spread of 34 basis points to the comparable Treasury (http://markets.ft.com/markets/bonds.asp ). On Apr 4, the 10-year German government bond traded at a yield of 3 percent (http://markets.ft.com/ft/markets/reports/FTReport.asp?dockey=GOV-040810 ). The common explanation for this downward trend of US and German government-bond yields is the flight of funds from riskier assets into the safe haven of government securities. Long-duration bonds have high risks of capital losses that may be amplified by a stampede out of the safe havens back into riskier assets. An inverted yield curve, or higher yields in short-term securities than in long-term securities, is commonly seen as a sign of recession while expansions are typically accompanied by upward sloping yield curves with yields of short-term securities below those of long-term securities (http://professional.wsj.com/article/SB10001424052748703321004575427822149953204.html?mod=wsjproe_hps_MIDDLEThirdNews). It is difficult to read much from the yield curve with the Fed working exotically on long, intermediate and short segments, maintaining short-term rates at zero and trying to control the rise of long-term yields. At some point the central bank will concede that it cannot fix the entire yield curve and that zero interest rates merely promote instability of financial variables by the carry trade from the dollar and yen into riskier futures and options on high-yielding currencies, commodities and equities (Pelaez and Pelaez, Globalization and the State, Vol. II, 203-4, Government Intervention in Globalization, 70-4). Targeting ceilings on long-term yields by expanding the Fed balance sheet is equivalent to the Fed writing an illusory put option or floor on prices of nearly all bonds that are priced to yield spreads over Treasuries. When the Fed put is discredited and abandoned, the selloff in bond markets will raise long-term interest rates in all segments. Declines in prices of mortgage-backed and asset-backed securities in general and haircuts in sale and repurchase agreements reduced funding capital of traders in the credit/global recession, causing common liquidity effects and flight to quality in multiple market segments as analyzed by Markus Brunnermeier and Lasse Pedersen (cited in Pelaez and Pelaez, Regulation of Banks and Finance, 223). The fire sale of bonds and rise of interest rates analyzed by Siegel and Schwartz would spread to all segments of bond markets. Leverage and risks of the magnitudes assumed by Fannie, Freddie and the Fed have never been dreamed in private financial institutions, which are governed by nonpolitical, stricter and consistent oversight.

VI Conclusion. Economic growth is failing to show the V shape in expansions following past sharp contractions and labor markets are under unusual stress. Legislative restructuring combined with anticipations of increases in taxes and interest rates create uncertainty in economic recovery and job creation that causes financial turbulence. Major policy shifts are required to promote growth and create jobs by reducing uncertainty in economic and financial decisions by business and households. Government is a critical institution acting as delegated agent with coercion powers on behalf of the principal, which is society, such that its resources originating in taxpayer contributions should be used parsimoniously to allow room for the private sector to generate prosperity and jobs (Go to http://cmpassocregulationblog.blogspot.com/ http://sites.google.com/site/economicregulation/carlos-m-pelaez)

http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )