Call me goofy, but I am not ready to join the “recession is over” parade just yet. While the economy has hit bottom, it is likely to stay bouncing along that bottom for many months at least. A rapid and sustained recovery beginning this fall is an improbable scenario.
In a spirit of fairness, we will begin by looking at the four main arguments supporting a near-term end to the recession. The first, and strongest, is the healing of the financial markets. The Standard & Poor’s stock index is up 12% for the year and 40% from its March lows. The flow of credit between banks has returned to normal as evidenced by the cost of borrowing. The yield spread between three-month LIBOR, which represents the costs of funds for large banks, and three-month Treasury bill yields has fallen from an astronomical 4.6% in October 2008 to 0.29% last week. Yield spreads between Treasury bonds and bonds issued by corporations and smaller governmental units have narrowed, making it cheaper for these entities to borrow. While there are still exceptions—it’s still next to impossible to securitize mortgages without a government guarantee—the financial markets are back to business as usual.
The second argument is that the $787 billion of stimulus to be provided by the economic recovery act has barely begun to flow. As more projects come on stream, the stimulus package will provide a substantial boost to growth. The stimulus, though, is just that, “something that incites to action or exertion or quickens action.” The question, that only time will answer, is whether stimulus-induced growth will be sustainable, or simply limited to projects whose jobs evaporate when they are completed.
The third argument, put forth cogently by FTN Financial Chief Economist, Chris Low, is that the traditional leader of economic growth—inventory rebuilding—will come to the rescue again. Inventory fluctuations were once a primary lever of economic decline and recovery. In the past, suppliers, caught by surprise, often needed many months to work off excess inventory when bad times hit. Then, equally surprised, they had to rebuild inventories quickly when good times started to return. The process tended to lengthen recessions with longer layoffs, but quicken recoveries with faster re-hiring. “Just-in-time” inventory management, imported from
Japan
in the 1980s, changed all that, and inventory levels played a minimal role in the mild recessions of 1991 and 2001. But, as Low points out, the current recession hit so hard and so fast that businesses had no time to manage inventories; they simply stopped making things. The corollary is that when the economy begins to rebound, inventory rebuilding will also have to be faster and more robust, and, in Low’s words, “slingshot growth.”
The fourth argument is in the interpretation of the data. Several recent government and private sector reports have been widely cited as evidence of an economic rebound.
· Housing starts in June rose by the largest percentage since 2004.
· New home sales increased 11%, the most since 2000.
· Pending sales of existing homes have risen nearly 20% from their January low.
The story on the employment front is similar.
· Initial weekly applications for unemployment insurance have been below 600,000 for the last five weeks, after having been above that level since the last week of January.
· Most importantly, job losses in July were the smallest since August 2008.
Government agencies and private groups pour out an endless stream of economic reports every working day. In each report, one number or percentage, the so-called “headline” number, stands out and seems to tell the whole story. But underneath it are mounds of detailed information that tell a more nuanced tale. Often, their interpretation is not merely a result of honest differences of opinion but of political, ideological, and financial motives. Also, the numbers themselves are far from reliable. They are seasonally adjusted, based on incomplete samples, and subject to frequent revisions. Finally, there’s the question of which data provide insights into the future and which merely offer a look in the rearview mirror.
With all these caveats in mind, let’s take another look at the data noted above.
· Housing starts rose 3.6% in July, but, at an annualized rate of 583,000 units, they are barely a third of the average for the last 10 years and a quarter of the boom period, 2004-2005.
· Pending sales of existing homes have also risen, but they remain down more than 13% from the pre-recession average.
· The four-week average of initial unemployment claims has fallen to 555,000, from a recent high of 659,000, but that’s still terrible by any but the most recent standards. From the end of the last major recession in the early 1980s to the beginning of the current recession, the four-week average of initial claims averaged 354,000 and never hit 500,000, except for one week at the peak of the 1991 recession.
· Job losses in July showed major improvement at “only” 247,000 compared to 741,000 in January. But the worst month for job losses in the 2001 recession was October with 325,000, and there were only two other months when losses exceeded 200,000. The worst month in the 1991 recession was February with 306,000 jobs lost, but again job losses exceeded 200,000 in only two other months.
To the extent this data is reassuring, other data is less so. As is well known, our economy runs on consumer spending, which accounts for 70% of Gross Domestic Product. And the consumer is still not spending. The Commerce Department reported recently that retail sales were down 9% between June 2008 and June 2009. On an annualized basis, that’s a difference of about $405 billion. Spending was down in almost all categories:
· Furniture & home furnishings: -12.6%
· Electronics & appliances: -11.5%
· Building materials: -13.0%
· Clothing: - 6.2%
· Department stores: - 9.4%
· Non-store retailers: - 6.7%
Consumer spending is off because consumer income is off. Wages and salaries paid to US workers in June were $6.24 trillion on an annualized basis. They have dropped every month since peaking at $6.58 trillion in August 2008. Had wages and salaries continued to increase at their pre-recession pace, they would have been about $6.69 trillion in June. That difference of $450 billion pretty much accounts for the drop in spending.
There is another dynamic at work too. Americans are paying down debt and saving at record rates. According to Goldman Sachs (and who could question them?) consumer and non-financial company debt fell 0.7% in the first quarter this year, marking the first contraction since 1952. The Federal Reserve reported that total consumer debt excluding debt secured by real estate, after rising steadily for decades, has fallen $80 billion since peaking in July 2008. We still owe more than $2.5 trillion, about where we were in October 2007. As the chart below indicates, we would have to cut another $550 billion more to turn the clock back just five years.
Personal savings has spiked recently as well. The Commerce Department reported that Americans socked more than $500 billion away in June and $680 billion in May. Since May 2008, we have been saving about 4% of our disposable income a month, double what we saved in the boom years.
The increase in savings leads to a key question: Will we go back to our old free-spending ways when the recession finally does end or is our newfound frugality permanent? Retail sales increased every quarter for seventeen years before the recession struck. “Never bet against the American consumer” was economic dogma. But things are different now. Americans have been scared into saving and two powerful forces—one demographic and the other economic—could keep that trend in place for a long time.
The demographic trend is the aging of the Baby Boomer generation. The older people get and begin to contemplate imminent retirement, the more prone they are to save, regardless of economic conditions. A recession can only reinforce this tendency. The economic trend is deflation, or at least the lack of inflation. The most serious previous recession since the 1930s occurred at the beginning of the 1980s. That recession, unlike today’s, was accompanied by double-digit inflation. Inflation discourages saving because it erodes the value of money. Who wants to put $1,000 in a CD if two years later its buying power has been reduced 30%? When the value of money is rising or stable as it is now, savers have a powerful incentive even if interest rates are low. Having been burned by the precipitous fall in stock prices and the even more catastrophic destruction of home equity, simply maintaining the cash you have is appealing.
I hope I am wrong. I hope the recession really is ending and recovery is beginning. If so, dear readers, you will have every right and my cordial permission to call me Mr Goofy from now on.
Of Spirits, both Animal and Human
Patsy’s spontaneous reaction was spot on. There is very little that’s rational about economic decision-making, or any other kind of decision-making for that matter. In his new book, Human: The Science Behind What Makes Us Unique, cognitive neuroscientist Michael S. Gazzaniga describes patients with injuries to a part of the brain that rendered them unemotional. One patient, for instance, “tested normally in intellectual ability, social sensitivity, and moral sense, and could devise appropriate solutions and foresee consequences to hypothetical problems, but he could never make a decision.” Gazzaniga’s conclusion from this study and much additional research is that “pure reason was not enough to make a decision. Reason made the list of options, but emotion made the choice….Even though we humans like to think of ourselves as being able to make non-emotional decisions, emotions play a part in all decisions.” (pp. 72-73)
Like Patsy and Dr Gazzaniga, we all know this. We know that even our most basic economic decisions about food, shelter and clothing—the things we need to stay alive—are heavily influenced by non-rational forces. Otherwise, who would ever wear high heels? Decisions about finance and business are no different. “Jack Welch’s phrase ‘straight from the gut’ sums it up: decisions that matter for investment are intuitive rather than analytical.” (p.144)
The authors of this assertion are George A. Akerlof and Robert J. Shiller. Akerlof is a Professor of Economics at the University of California, Berkeley. He won the Nobel Prize for Economics in 2001 and is married to Janet Yellen, the former President of the Federal Reserve Bank of San Francisco. Shiller is Professor of Economics at Yale and co-creator of the influential Case-Shiller Home Price Index. Earlier this year they published Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism. The book’s premise is that the current economic crisis “was caused precisely by our changing confidence, temptations, envy, resentment, and illusions—and especially by changing stories about the economy.” (p. 4) The authors call these emotional forces “animal spirits” following John Maynard Keynes, the famous British economist who coined the term in the 1930s. Keynes believed that animal spirits, or “the spontaneous urge to action,” are the essential motivation behind business decisions. But while Keynes’s economic prescriptions form the heart of the global financial rescue plan, and his description of how capitalist economies function is more or less gospel, his conclusions about how decisions are made have been largely discarded.
Although purportedly written for a general audience, Shiller and Akerlof are not really focused on lay readers. Their true target is academic economists. The book is filled with what can only be called blatant rebukes to the profession. Here is just a sampling:
“Natural rate theory (the idea that there is a sustainable level of unemployment that keeps inflation in check) is now economists’ conventional wisdom. It is accepted by the vast majority of economists—but we do not believe it to be true. And it has also been the justification for economic policy of great foolishness.” (p 107)
“Over the years economists have tried to give a convincing explanation for aggregate stock price movements in terms of economic fundamentals. But no one has ever succeeded.” (p.131)
“The theories economists typically put forth about how the economy works are too simplistic.” (p.146)
“The real problem, as we have repeatedly seen in these pages, is the conventional wisdom that underlies so much of current economic theory.” (p.167)
I could go on, but you get the point.
So why do academic economists refuse to take animal sprits into account? Why do “they fail to consider the most important dynamics underlying economic crises”? (p. 167) Shiller and Akerlof get part of the answer to these questions, but they too are part of the academy and they cannot or will not follow their conclusions to the source.
The part they get is that economists have insisted on a theory based on rational behavior because it can be quantified and modeled. “In their (that is, economists’) attempts to clean up macroeconomics and make it more scientific, the standard macroeconomists have imposed research structures and discipline by focusing on how the economy would behave if people had only economic motives and if they were also fully rational.” (p. 168) Dear reader, I will make you a deal. I know there are a lot of quotations in this commentary, but I promise not to include any more if you re-read this one slowly and carefully.
Good. Now, what Shiller and Akerlof don’t get is why economists wanted to “clean up macroeconomics and make it “more scientific.” For the answer we have to go back to 1957. In that year, the Soviet Union successfully launched Sputnik, the first artificial satellite. It was the height of the Cold War, and America was stunned. The Federal Government responded in the best American tradition: It threw massive amounts of money at universities for mathematical and scientific research so that we would not lose the Space Race. Suddenly, brand new physics and chemistry buildings sprang up on campuses across the country. Professors got grants for all the equipment and graduate students they wanted. The liberal arts had to make do with the dowdy old buildings the scientists abandoned. The message was obvious. Science equals money, power, and prestige. Economists realized that if their field became a science, a Social Science, they could cash in too.
There were two problems with this change of direction. Since the discovery of relativity and quantum mechanics in the first quarter of the 20th century, the advances in the hard sciences have required increasingly more difficult and abstruse mathematics. The math has made it all but impossible for non-scientists to follow new developments, which is why so many books and articles on physics and biology for laymen are published every year. Scientists want their discoveries understood by the widest possible audience. Altruism and a desire for recognition undoubtedly play a role in this spate of publications, but scientists know that without public support, their funding could be threatened. An informed public is clearly in their interest. Economists faced exactly the opposite situation. The father of economics, Adam Smith, did not include any calculations or statistics in his 1776 masterpiece, The Wealth of Nations. Things didn’t change much in the next two hundred years. Economics was a qualitative discipline that required no special mathematical knowledge. It was more or less accessible to any reasonably well educated person. To become a “real” science, Economics (with a capital E) had to become less accessible and more quantitative.
That led to the second problem. At some level, economists knew just as well as everyone else that economic decisions aren’t rational. But you can’t be a scientist unless you can make mathematical models, and irrationality is extremely hard to model. So economists made models using assumptions of rational behavior in hopes that they would be close enough to reality to be useful.
But they aren’t. Economists have been no better at predicting the economic future than anyone else. Oh sure, a few predicted the 1987 stock market crash, and a few predicted the long boom of the 1990s, and a few predicted the dot-com bubble, and a few predicted the spectacular rise in home values, and a few predicted the housing debacle that followed. But nobody predicted all or even most of it. And economists aren’t even very good about predicting the past; the causes of the Great Depression remain a subject of debate.
It may seem that I am specifically attacking the economics profession for short-sightedness, greed, or vanity. Not really. I have singled out economists only as an example. The heart of the matter is categorization. The 20th Century was all about putting things into categories, creating specialties, and making experts. Economics, considered as specific academic discipline is as artificial as Sputnik, and so are chemistry, Russian literature, and playing the clarinet. Perhaps no one person can be proficient enough to earn PhDs in all these fields, but that simply speaks to our limitations as human beings. The fields themselves are all parts of the human and universal condition. They are not inherently discrete, and many people have a good understanding of and keen interest in them all and more besides. Twenty-first Century communications, globalization, and the interactive Internet community are rapidly breaking down the barriers between disciplines that were so painstakingly erected in the previous century. In this century “doing the math” will only be a part, and small part of understanding economics. A full understanding will require “doing” and blending the cognitive science, the psychology, the sociology, the history, the linguistics and maybe even clarinet playing. Welcome to the Fun House.
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