It would be the grossest of understatements to observe that the economics profession hardly covered itself with glory by its abysmal forecasting record over the past two years. Not only did most Wall Street and academic economists fail to foresee the severity and length of the worst postwar U.S. economic recession; for the most part, they strongly doubted that the bursting of the largest U.S. housing bubble on record would result in a recession at all.
Seemingly un-chastened by their display of excessive optimism in 2008 and 2009, the consensus of economic forecasters is now cheerfully predicting a V-shaped U.S. economic recovery in 2010. In so doing, they seem to be oblivious to the strong historical experience suggesting that severe financial crises are uniformly followed by the shallowest and weakest of economic recoveries. They also seem to be turning a blind eye to the many obstacles to U.S. economic recovery that are presently all too much in evidence.
Indeed, it is more reasonable to expect an L-shaped rather than a V-shaped U.S. economic recovery in 2010. There is also a real risk that the U.S. economy will experience a double-dip recession in the second half of 2010 as the supportive effects of the fiscal stimulus package wear off. My case rests in part on the fact that the Great Economic Recession of 2008–09 differs fundamentally from the 11 postwar economic recessions that preceded it. More important, it rests on the facts that the present U.S. economic recovery faces the strongest of economic headwinds, and that recovery is occurring in an international context of considerable weakness in the European and Japanese economies.
A Very Different Recession
With the exception of the two economic recessions that followed the 1973–74 and 1979 international oil price shocks, all previous postwar U.S. recessions have followed a similar pattern. In the run up to each, an excessive bout of investment, especially in the residential real estate sector, provoked a boom. Fearful of the potential inflationary consequences of the boom, the Federal Reserve typically responded by raising interest rates to a level that effectively strangled it. Once the Federal Reserve judged the economy to have cooled off sufficiently to prevent inflation, it generally reduced interest rates to a level that was low enough to restart the investment cycle.
Ever optimistic, the majority of economic forecasters, especially on Wall Street where they are paid to be optimistic, is now choosing to underplay how fundamentally different the recent Great Recession has been from the typical postwar kind. For a start, these forecasters fail to recognize that the underlying cause of the Great Recession was the bursting of the largest U.S. housing market bubble on record. The bursting of that bubble, coupled with a major equity market correction, resulted in the largest reduction of U.S. household wealth in the past eighty years. More important, the optimists choose to ignore the fact that the depth of the Great Recession was the result of the bursting of a super credit bubble, which resulted in a “once in a century” financial market crisis. That crisis has rendered the U.S. banking system dysfunctional in a manner that is all too reminiscent of what had occurred in Japan’s “lost decade” of the 1990s.
The optimists are downplaying the most devastating destruction in personal wealth since the Great Depression. A major part of this destruction has been the result of a 30 percent decline in U.S. home prices from their peak in September 2006. Further contributing to this destruction has been the 25 percent decline in U.S. equity prices from their mid-2008 peaks, a percentage decline that includes the substantial rebound in equity prices since March 2009. According to the Federal Reserve, the decline in home and equity prices over the past 18 months has resulted in a loss of household wealth totaling $12 trillion, or the equivalent of 80 percent of annual U.S. GDP. One has to expect that this loss of wealth will induce a meaningful change in U.S. household savings behavior as households seek to repair their devastated balance sheets.
Of perhaps greater significance than the recent loss in U.S. household wealth has been the puncturing of what George Soros refers to as the U.S. super credit bubble of the past three decades. This credit bubble cut across all the major sectors of the U.S. economy including households, government and the U.S. financial sector. A striking feature of this super credit bubble is that by the end of 2008, total U.S. credit outstanding amounted to about 350 percent of U.S. GDP. This credit explosion dwarfed that of the late 1920s and 1930s, whose bursting was the prelude to the Great Depression. Past experience with the bursting of such bubbles would suggest that a prolonged and painful period of debt deleveraging lies ahead for the U.S. economy.
The bursting of the U.S. credit market bubble, coupled with the sub-prime lending crisis, has wreaked havoc not simply across the U.S. banking system but also across those of the Euro-zone and of the United Kingdom. According to International Monetary Fund (IMF) estimates, total U.S. bank loan losses will in the end exceed $1 trillion, of which total the U.S. banks have to date recognized only around $600 billion. On a relative basis, the IMF is estimating that bank loan losses will constitute even greater problems for the United Kingdom and the European economies. This would seem to suggest subdued global lending in the year immediately ahead.
The extensive research by the IMF and by Professors Kenneth Rogoff and Carmen Reinhart should provide a cautionary tale to optimistic economic forecasters and to economic policymakers as to what to expect in the aftermath of a severe financial market crisis. Drawing on the various experiences of the Great Depression, Japan’s lost decade in the 1990s, the Nordic banking crises of the early 1990s, and innumerable emerging market financial crises, Rogoff and Reinhart’s research conclusively suggests that one should expect only a very gradual recovery after a financial crisis of the severity that the United States is now experiencing.1
Indeed, Rogoff and Reinhart’s research suggests that, in the aftermath of a major financial crisis, it takes on average more than four years for an economy to recover its pre-recession peak and an even longer time for full employment to be restored. In light of this research, it would seem that the onus rests squarely on the optimists to explain why this time the U.S. economic recovery will be any stronger than the weak recoveries that followed previous episodes of major financial crisis. The optimists’ case seems all the more difficult to prove in the context of a synchronized global economic recession that precludes the possibility of any meaningful export-led recovery.
The optimists argue that the current recession episode differs from previous ones in that it has been met by a prompt and very powerful policy response. In that context, they point to the $780 billion Obama fiscal stimulus package of March 2009. Spread over 2009–11, that package amounted to the equivalent of 5 percent of U.S. GDP, making it the largest peacetime stimulus package on record. The optimists also emphasize that the fiscal stimulus has been supported by an extraordinarily accommodating monetary policy by the Federal Reserve. For not only has the Fed reduced interest rates to 0–0.25 percent and repeatedly emphasized that it has done so for “an extended period”, it has also substantially expanded the size of its balance sheet from about $800 billion prior to the crisis to more than $2 trillion at present. It has done so in a deliberate effort to support the economy with a great liquidity infusion to the financial system.
An important factor overlooked by the optimists is the paltry response of the U.S. economy to date to the massive amount of policy support it has been receiving. Following an unprecedented four quarters of negative economic growth, during the third quarter of 2009 the U.S. economy managed to grow at a mere 2.2 percent annualized rate. And it did so despite the fact that the fiscal stimulus alone contributed as much as 3.5 percentage points to U.S. economic growth. This has to raise the very real question of whether the U.S. economy will experience a double dip recession in the second half of 2010, once the beneficial impact of the fiscal stimulus on GDP growth has faded.
The optimists have also overlooked a stark reality: the very strong headwinds confronting the U.S. economy, which almost certainly guarantee the most sub-par of U.S. economic recoveries. Among the more important of these headwinds are the following:
- Extraordinarily large gaps in the U.S. labor market, which will preclude the income growth needed to support a consumption-led economic recovery.
- A still highly dysfunctional financial system that is not in a position to provide the credit growth needed for a meaningful economic recovery.
- An impending deepening in the commercial real estate bust that is almost certain to result in a debilitating wave of regional bank failures.
- A likely 5–10 percent additional decline in U.S. home prices as the cresting wave of home foreclosures finds its way onto an already glutted U.S. housing market.
- Large pro-cyclical expenditure cuts and revenue hikes by state and local governments, as these governments are forced by statute to balance their budgets. The prospective tightening of at least $100 billion in state and local government budget deficits in 2010 will be a major offset to the Federal fiscal stimulus package, and it will more than likely compound the country’s chronic employment problem. It is estimated that the state governments alone would have registered a cumulative deficit of more than $350 billion in 2009 and 2010 in the absence of corrective action. Such a deficit would be more than double the $140 billion in Federal transfers that the states are to receive under the Federal stimulus package, which will necessitate savage cuts in state budgets.
- A very difficult international economic context as Japan struggles with serious deflation and as the Eurozone is severely tested by emerging fiscal crises in Greece, Ireland, Spain and Portugal.
Consumers on the Ropes
The most serious of the headwinds confronting the U.S. economy is the appalling state of the labor market, which is now weighing very heavily on income growth. The headline unemployment rate has risen above 10 percent, close to a postwar high. There has also been an unprecedented increase in involuntary part-time employment as companies have responded to the recession by cutting back sharply on hours worked. If you include discouraged workers and involuntary part-time workers in the unemployment total, as does the Labor Department in its U-6 unemployment measure, the overall unemployment rate is seen to have risen from 9 percent prior to the recession to a staggering 17.5 percent of the U.S. labor force at present.
The opening up of extraordinarily large labor market gaps has already exerted considerable downward pressure on household income growth. Over the past year, U.S. wages have fallen by about 4 percent, while the only meaningful increases in after-tax personal incomes have occurred in the months in which there have been large income tax cuts. Sadly, one has to expect that the large labor market gaps will persist in 2010, with the headline unemployment rate likely to remain in excess of 10 percent throughout the year. Any recovery in the economy is more than likely to be met by companies increasing hours worked of those already employed rather than by their adding workers to their employment rolls.
The likelihood of flat or even declining income growth in 2010 does not bode well for the prospects of a consumer-led economic recovery. This is especially the case in the context of seriously impaired household balance sheet positions, as underlined by a level of household debt close to a record 135 percent of U.S. household incomes. Any attempt by U.S. households to repair those balance sheets by increasing their savings rates toward more historically normal levels will prove to be another drag on household consumption that presently accounts for as much as 70 percent of U.S. aggregate demand.
A further factor clouding the prospect for any meaningful recovery in U.S. consumption in 2010 is the ongoing cutback in consumer lending. During the boom years, households withdrew equity from their homes to finance their profligate ways to the tune of a full 8 percentage points of their incomes each year. With the bursting of the housing market bubble, mortgage equity withdrawal has totally evaporated. At the same time, banks have seriously cut back on credit card lending. As a result, overall consumer lending has been declining for the first time in more than sixty years, and this decline shows little signs of abating.
The Japanese experience of a “lost decade” in the 1990s should be a stark reminder that a necessary condition for any meaningful U.S. recovery in the aftermath of a major financial crisis is the restoration of bank lending. In that context, one has to be concerned that U.S. bank lending is still being cut back despite the unprecedented liquidity creation by the Federal Reserve. Rather than lending, banks continue to hoard capital in an attempt to repair damaged balance sheets. This is having a particularly adverse impact on the U.S. small- and medium-sized business sector, which accounts for about 40 percent of overall U.S. employment and which, unlike the large enterprises, does not have ready access to the securitized credit market. A recent survey suggests that more than 75 percent of small- and medium-sized enterprises are experiencing tightening conditions on their credit cards, on which they are heavily reliant for financing.
Sadly, the prospects for an early resumption of U.S. bank lending appear dim. According to IMF estimates, U.S. banks are yet to recognize about $400 billion in loan losses from past poor lending decisions. There is also the very real risk that these loan losses could increase in 2010 as household defaults increase further in response to rising unemployment. In this connection, one might note that with unemployment above 10 percent it is all too likely that economic conditions in 2010 will be worse than the “worst case scenario” envisaged by Treasury Secretary Timothy Geithner in his stress test for the 19 largest U.S. banks last February.
A Commercial Real
In recent speeches, a number of Federal Reserve Governors have voiced their concern that the U.S. economy might still have to weather a further significant downward movement in commercial real estate prices. Heightening their concern is the fact that about $500 billion in commercial real estate bank loans are due to mature in 2010. Should these loans not be rolled over, there could be additional selling at a time that the commercial real estate market is already under considerable pressure. This might force banks to further mark down the $3.5 trillion in commercial real estate loans on their books, which would only prolong the present credit crunch.
A further downward lurch in commercial real estate prices would deal a particularly serious blow to U.S. regional banks, since commercial real estate loans generally exceed 50 percent of their overall loan portfolios. In response to the weakening in the commercial real estate market, the Federal Deposit Insurance Corporation has publicly indicated that it has placed about 540 banks on its troubled list. Meanwhile, several respected private bank analysts are suggesting that more than 1,000 regional banks could fail in the current credit cycle.
A Still-Stabilizing Housing Market
At the start of the Obama Administration, Larry Summers correctly noted that stabilization in U.S. home prices was a necessary condition for a sustainable U.S. economic recovery. This reasoning prompted the Obama Administration to introduce a variety of initiatives aimed at promoting mortgage loan modification to forestall U.S. home foreclosures. Despite these initiatives, however, the pace of U.S. home foreclosures has continued to rise at an alarming rate in 2009 as unemployment has increased, and as an increasing proportion of homeowners now find themselves with substantial negative equity positions in their homes.
A real risk to the U.S. economy in 2010 is that the wave of foreclosed properties that will be hitting an already saturated home market could cause home prices to fall 5–10 percent below present levels. That would delay the slow healing process presently underway in the U.S. financial system, prolonging the credit crunch.
As the U.S. economy enters 2010, it does so with the most fragile of economic recoveries that is now being challenged by a whole host of domestic economic problems. The U.S. economy also confronts a global economy being seriously challenged by renewed deflation in Japan and serious tensions within the Eurozone. These considerations make it highly implausible that Wall Street’s dream of a V-shaped recovery will materialize. Instead, policymakers should brace themselves for the “L”, which itself could easily give way to a double dip when the present fiscal policy support to GDP growth fades in the second half of the year. One has to hope that policymakers soon come to the realization that the last thing that the global economy needs right now is a premature exit from the policy stimulus of the past year.