2008 Review Part 3

OUTLOOK FOR GDP |

The outlook is extremely bleak. The current recession is in its 13th month. Most recessions over the last 60 years have ended by this time. This one not only has not ended, downward momentum is intensifying.

Q3 GDP

The revised estimate of Q3 GDP growth was -0.5%. This figure will be revised once more. The final number will be reported in the coming week and is expected to be revised down to between -0.6% and -0.9%.

Real consumer spending declined at an annual rate of 3.7% in the third quarter(likely to be revised down to -4.0%), the first negative quarter since 1991 and the worst negative quarter since the second quarter of 1980. Unfortunately, based on the severe decline of 4.7% in nominal retail sales from September through November, consumer spending is likely to fall further in the fourth quarter, which would make the current recession comparable in ugliness to the 1973-75 recession.

Capital spending, which was supposed to be the bright spot because of export strength earlier in the year, fell at a 5.7% annual rate in the third quarter. This was the weakest quarterly performance since 2002 when the tech wreck was still unfolding. The decline was concentrated in old economy industrials and transportation equipment. But even technology capital spending growth shrank from 7.9% in Q2 to 2.5% in Q3.

Residential construction fell at a 17.6% annual rate – the 11th consecutive quarterly decline. Not since the Great Depression has housing been so weak for so long. Growth was positive in nonresidential construction but slowed to 6.6% from 18.5% in the second quarter. Based on anecdotal reports, increased credit stringency and collapsing consumer spending, substantial negative growth in nonresidential construction is now underway and will prove to be very troublesome for lenders who have specialized in this sector.

Net exports, still benefiting from the surge in exports triggered by a weak dollar prior to September, added 1.1% to GDP growth in the third quarter. Government added 1.2% (primarily defense related) and inventory accumulation added 0.6%. Without these favorable factors, GDP would have been reported as -3.2%. With the dollar’s value now rising sharply and global recession in full sway, the addition to GDP from net exports will reverse in the fourth quarter. The same can be said about inventory accumulation, which almost certainly is involuntary right now as sales fall faster than businesses can cut back on production.

GDP Forecast

GDP growth over the next two quarters will be very negative. The two GDP forecast scenarios shown in Chart 1 – severe recession (base case) and depression (what do you call a recession that is worse than severe?) – both indicate that 2009 will be a very difficult year.

In the severe recession scenario – base case – the unemployment rate peaks at 9.6% in the first quarter of 2010 and 2009 real GDP growth is -0.8% fourth quarter to fourth quarter and -1.2% year over year; the worst quarter is the second quarter of 2009 at -1.7% over the previous 12 months. In the depression scenario unemployment peaks at 10.6% in the fourth quarter of 2010 and 2009 GDP growth is -1.1%; the worst quarter is the second quarter of 2009 at -2.0%. Based on forecasts from others, it appears that my unemployment estimates are high and my forecast decline in real GDP is too low.

To put these scenarios into historical perspective, the 12-month rate of real GDP growth fell to 0.3% at the bottom of the 2001 recession, but growth did not contract. In earlier recessions GDP growth bottomed at -1.1% in the first quarter of 1991, -2.7% in the third quarter of 1982, -2.3% in the first quarter of 1975.

Economists have busy revising down 2009 real GDP growth estimates. My econometric model’s estimate is -1.2%, which I believe greatly understates the downside risk. Merrill Lynch expects -2.9%; Goldman Sachs expects -1.6%; and Global Insight expects -1.8%.

Obama Administration Likely To Enact Substantial Fiscal Stimulus

Greatest Negative Demand Shock Since the Great Depression. The economy is currently experiencing the worst negative demand shock since the Great Depression. A massive demand shock causes a precipitous decline in spending in all sectors of the economy – consumer, business, state and local government and net exports. The collapse in spending causes revenues and incomes to fall and reinforces the downward momentum of the demand shock on spending.

Liquidity Trap – Monetary Policy Becomes Ineffective. Traditional policy measures include monetary and fiscal policy. Monetary policy focuses on reducing the cost of credit by lowering interest rates and providing ample liquidity. The intent is to strengthen demand by making credit cheaper and easier to

access. However, in the current cycle monetary stimulus has become ineffective because credit markets, which are the conduits through which monetary policy works, have either disappeared altogether or are barely functioning. The financial sector has fallen into a classic liquidity trap in which risk aversion is so intense that zero interest rates and unlimited liquidity have no effect on spending activity.

Fiscal Policy. The other traditional policy tool to stimulate demand is fiscal policy. This can come either in the form of tax cuts (rebates) or spending. Each dollar of fiscal stimulus can have a decidedly different impact in treating and moderating the current demand shock depending on how it is disbursed. Timing is also an issue. For example, infrastructure spending has a high effective spending multiplier and produces substantial improvements in productivity over time but infrastructure projects take a long time to get up and running and therefore have very limited short-term benefits in offsetting a massive decline in spending.  Tax rebates are relatively immediately but they may go into debt reduction and saving rather than offset lost spending.

TARP (Troubled Assets Relief Program) Is Defensive, Not Stimulative. For example, the $335 billion in TARP out of $700 billion that has been earmarked to date will have almost no immediate impact on stimulating demand. Almost all of this money will be invested in financial institutions and simply replace private sources of capital that have disappeared because of the seize-up in credit markets. That is not to say these investments are unimportant. They are very important because they are preventing the potential total collapse of the private financial system. Such a collapse, were it to occur, would greatly exacerbate the

negative demand shock. Preventing a financial system collapse avoids this outcome but it does not induce financial institutions to extend new credit in the face of greater risks. Once financial markets stabilize and private capital flows loosen up, TARP funds will be returned quickly to the federal government. So,

TARP should be viewed as a preventive and defensive policy measure, not as a stimulus measure.

Tax Rebates. To arrest and reverse the downward momentum of the demand shock fiscal policy must focus on stimulating spending that creates jobs and incomes and that restores sufficient confidence in the future so that risk aversion moderates and businesses and consumers begin spending again. In early 2008 Congress enacted a tax rebate program that returned about $100 billion to consumers, equal to about 1% of disposable income. While there is no definitive study available that explains exactly what happened to these dollars, the subsequent massive deterioration in the economy and flow of funds data, which show that consumers reduced debt during the third quarter, imply that a vast amount of the money went into debt liquidation and saving. That helps consumers repair balance sheets, just as TARP funds have a similar effect for financial institutions, but the dollars don’t get spent and so they don’t help much in arresting the demand shock and they certainly didn’t reverse the shock. Indeed, the shock gained considerable momentum after the tax rebates had run their course.

Transfer Payments – Unemployment Benefits and Food Stamps. There are other kinds of spending, such as extending unemployment benefits and food stamps, that unquestionably lead almost immediately to higher consumer spending, particularly in times of rapidly rising unemployment such as now. So, some of the pending fiscal stimulus will go to such programs.

Reduce Tax Withholding and Payroll Tax Schedules. This would be easy to implement quickly but is not likely to have an impact much different from tax rebates. Also, reducing payroll taxes for social security and medicare would further exacerbate the long-term solvency of those programs.

Targeted Grants to State and Local Governments. Unlike the federal government state and local governments are required to balance spending with revenues. When the economy contracts state and local tax revenues also contract leaving states with little option but to cut spending or raise taxes. Both actions reinforce the negative demand shock.

The National Conference of State Legislatures reported that 30 states face a combined deficit of $30 billion in fiscal 2009 and 25 expect a deficit of $60 billion in 2010. Like the initial estimates of subprime lending losses, these numbers are bound to grow by leaps and bounds as the economy continues its relentless deterioration. California alone faces a 2009 budget deficit of $15 billion.

Federal stimulus can ease the impact at the state and local level by allocating stimulus dollars. Some dollars can be immediately deployed, such as Medicaid benefits. But stimulus dollars for other programs, particularly infrastructure projects. will be dispersed over time.

Federal Spending Programs. There has been much talk about systematic underinvestment in infrastructure over the last several years and the need to reverse that neglect. There is little doubt that investment in infrastructure will benefit long-term growth, but it is difficult to deploy infrastructure investments quickly and thus this kind of stimulus will have limited short-run benefits.

President-elect Obama has already emphasized the importance of infrastructure in the following areas: energy-efficient public buildings, modernize and upgrade school buildings, increase broadband adoption, modernize health care system through technology, light rail and other national infrastructure projects.

Possible Composition of Stimulus Package. The Center for American Progress has suggested $350 billion in one-time programs:

Or, grouped somewhat differently:

About 50% of this proposed list is for infrastructure projects but perhaps as little as 10% of that is ready to go.

Goldman Sachs has suggested a more expansive two-year stimulus package:

Size of Stimulus Package. While the programs suggested above total $350billion, as the economic crisis has deepened, policy discussions increasingly have focused on larger numbers in a range of $500 to $700 billion over two years. Knowledgeable observers suggest that a large stimulus size would have to come from additional tax reductions rather than spending increases, if it is to have much additional impact in the near term.

Merrill Lynch asserts that stopping the recession dead in its tracks and holding the unemployment level at 6.7% would require a budget deficit of 14% of GDP in 2009. This would amount to a deficit of $2.0 trillion, about $1.0 to $1.1 trillion above the projected 2009 fiscal deficit without any further stimulus. Merrill suggests further that a $600 billion stimulus program would be required to merely offset the income projected to be lost by the private sector during 2009.

It will be increasingly difficult to gauge the impact of the reported federal budget deficit on the economy because some of the dollars, like most TARP funds, will be included in the reported deficit, but will have little if any direct impact on spending. For example, the budget deficit for September and October 2008 was nearly $250 billion above the deficit for the same months in 2007. However, this increase included $191 billion in TARP outlays and $14 billion in funds obligated in the Fannie Mae and Freddie Mac conservatorships. Most of this $205 billion increase will have little stimulative impact.

Economic Impacts of Stimulus. All GDP forecasts will be revised once the outlines of the Obama Administration’s fiscal stimulus package become public. I have attempted to show the potential impact of stimulus on GDP growth over the next three years in the Fiscal Stimulus scenario in Chart 1. I assume approximately $700 billion in additional spending split $400 billion between fiscal 2009 and $300 billion in fiscal 2010. This is slightly more aggressive than the Goldman Sachs estimate. This stimulus is added to the Severe Recession scenario.

Stimulus improves real GDP growth from -0.8% in 2009 to -0.3%; from 1.4% in 2010 to 2.0%; and from 1.1% in 2011 to 1.6%. Core PCE inflation, which is falling rapidly and is forecast to turn into -2.2% deflation during 2010, falls a smaller -1.4% and then returns to zero by the end of 2011. The inflationary impact of stimulus in a deflationary environment is an extremely important and positive policy outcome.

Threat of Pernicious Deflation and a Perpetuating Negative Feedback Loop. Falling aggregate demand and price deflation are a deadly combination for the financial system. Debts are denominated in nominal dollars but in a deflationary episode incomes decline not only because unemployment rises but because wage and salary rates are first frozen and then cut outright. This means that in a deflationary environment it becomes increasingly difficult for employed people to service their debts. This will inevitably result in increases in defaults and bankruptcies. Such an outcome must be avoided at all costs because if it takes hold, the current collapse in aggregate demand will extend, deepen and lock into a perpetuating negative feedback loop. This is what economists refer to as pernicious deflation – or as Irving Fisher called it, “the debt-deflation cycle”. It is a very real and serious threat. It is one that precious little attention has been paid to as many economists continue to obsess about the risks of inflation. This is hardly the time to worry about future inflation. The consequences of pernicious deflation to our economy and social stability are much greater and the threat is much more imminent than the possibility and consequences of runaway inflation.

This is part 3 of our four part series of Bill Longbrake’s review of 2008 and the ongoing credit crisis. Bill Longbrake is the former Deputy to the Chairman and CFO of the Federal Deposit Insurance Corporation and Vice Chairman of Washington Mutual. He is currently on the Board of Directors for First Financial Northwest.

Originally published as Bill Longbrake MEMORANDUM, December 15, 2008, RE: Economic Commentary – Massive Negative Demand Shock Threatens Worst GDP Performance Since the Great Depression; Specter of Pernicious Deflation Lurks.

*Artwork from Iron Man Records under a Creative Commons license at Flickr.com.