WHY THIS SLUMP IS DIFFERENT
The news certainly has not been good of late. Many top economic analysts conclude the United States has entered a recession, defined as two successive quarters of shrinking gross domestic product (GDP). Global Insight, a Boston-based macroeconomic consulting firm, concludes the United States is already there, projecting a drop in GDP of 0.1% in the first quarter of 2008 and a 0.7% decline in the second quarter.
While the lag in collecting quarterly GDP data means we won’t know for sure until later this year whether the GDP has actually shrunk during the first half of 2008, there’s no doubt we are in the middle of a painful economic slowdown.
The Conference Board’s index of leading indicators, released in March, decreased 0.3% in February, the fifth straight month of decline. Higher initial claims for unemployment insurance, fewer building permits and lower consumer expectations pushed the index down and more than offset the positive contributions from the money supply and interest rate spread. The leading index declined 1.5%—about a 3% annual rate—during the six-month span from August 2007 to February 2008. The last time the leading index worsened for six consecutive months was in early 2001. At the same time, real GDP growth fell to 0.6% in the fourth quarter of 2007, down from a 4.9% annual rate in the third quarter and an average of 2.2% annual rate in the first half of 2007.
The current behavior of the Conference Board’s leading, coincident and lagging composite indexes suggests economic weakness is likely to continue in the near term.
SLOWDOWN WITH A DIFFERENCE
Recession or slowdown, the current economic slump is vastly different from the last major economic downturn, the 2001 recession. Daniel Meckstroth, chief economist for the Manufacturers Alliance/MAPI in Arlington, Virginia, notes that recession was precipitated primarily by a collapse in a relatively small segment of the economy, the “dot-com” industry. The value of dot-com stocks had been pushed to almost unimaginable levels by day traders and speculators. Those stocks, however, were a relatively small 6% of the $17.2 trillion in total equity capitalization of the U.S. stock market by the end of 1999. But when the technology stock bubble burst, it led to a market correction that swept through the entire non-residential business investment sector.
Of course, the Sept. 11, 2001, terrorist attacks also dramatically impacted the economy, with the U.S. stock market closing for four days, paralyzing the United States and world financial systems. The terrorist attacks, combined with the dot-com meltdown, caused real GDP to fall by 1.4% in the third quarter of 2001.
Today’s economic slowdown has an entirely different set of factors behind it.
Housing. By now, the story is well known. Low mortgage interest rates and bank promotions of home equity loans in the 2001–2004 period made the housing boom possible. As interest rates started to rise in 2005, banks and mortgage brokers promoted subprime loans with low initial rates and little or no downpayment requirements. Housing prices peaked in 2005 and then began to decline. As housing prices fell, subprime mortgage defaults increased and mortgage-backed securities held by investors declined in value.
In recent testimony, Allen Sinai, chief global economist with New York-based Decision Economics Inc., observed the fall in housing prices—and the ensuing economic slowdown—is reverberating through financial markets and balance sheets in the global economy. He noted that housing, which was a major lever for the boom, is now a major lever for the downturn. As U.S. consumers and businesses cut back, the unemployment rate rises and the economy of other countries, whose growth has in part depended on the U.S. economy, also starts to slow.
Housing played no part in the 2001 recession. In fact, housing prices rose in the late 1990s and 2001, helping offset the decline in stock prices. Consumers were able to tap into the equity on their homes to maintain living standards. In 2008, the story is very different, with the wrenching adjustment to the subprime crisis causing sharp cutbacks in new home construction and massive losses in the financial industry from securitized and collateralized mortgage loans.
Non-residential investment. In 2001, over-investment in physical capital led to a decline in non-residential investment and a severe inventory correction. Cutbacks in non-residential investment reduced GDP by 0.5%, and inventory reduction caused a 0.9% reduction in GDP. In 2008, by contrast, non-residential investment has not been a factor in the downturn. Indeed, businesses have been careful not to over-invest in software, plants and equipment.
Value of the U.S. dollar. Between 1995 and 2001, the U.S. dollar appreciated by 29% against the world’s major currencies. The overvalued dollar made U.S. exports uncompetitive; as a result, net exports fell and slowed economic growth. Today, U.S. exports are growing strongly, due in part to the 28% decline in the dollar value relative to major currencies since 2001.
Consumer debt loads. Consumer debt peaked at a record high of 19.6% of disposable income in late 2006, with debt obligations high relative to income. Unlike in 2001, consumers will not be able to count on home equity loans to maintain or increase spending on goods and services. The lack of a fallback to support consumer spending could further slow U.S. economic recovery.
Inflation. Price increases in the late 1990s to 2002 were not large enough to be an obstacle for policymakers seeking to stimulate growth. The Consumer Price Index for All Urban Consumers (CPI-U) increased by an average of only 2.3% from 1998 to 2002. The lack of inflationary pressure allowed the Federal Reserve Board to reduce the federal funds rate from 6.24% in 2000 to 1.13% by 2003.
In contrast, inflation has become an issue for U.S. policymakers in 2008. Consumer prices have risen by an average of 3.3% from 2005 to 2007, and at a 4% annual rate from February 2007 through February 2008. As a result, the Federal Reserve Board has less leeway to cut interest rates for fear of adding to inflationary pressures and further reducing the value of the dollar against major currencies.
RECOVERY CHALLENGES AHEAD
The challenges for current U.S. policymakers and for those who will take office next year also differ from those of 2001. Promoting strong, sustained economic growth this year and in the future will require even greater efforts to balance competing goals and political agendas. There are several factors to consider.
Productivity slowdown. Global Insight reports the longterm fundamentals of the United States have deteriorated. Data from the Bureau of Labor Statistics shows that labor productivity—the key measure of the economy’s long-term health—advanced only 1.6% from 2005 to 2007. This is a sharp drop from the 3.5% rate of productivity increase in the 2002 to 2004 period. Earlier in this decade, advances in information technology boosted productivity numbers, but that boost has apparently come to an end. In fact, Global Insight projects productivity will advance at a rate of only about 2% annually, below its average for the past 50 years.
Tax increases. The possibility of federal tax increases after the next election could also slow economic recovery. In an analysis of the economic and job-generating power of the federal tax cuts enacted between 2001 and 2006, Sinai concludes that without those tax cuts, including cuts on personal income, dividends and capital gains, U.S. GDP would have been 0.7% lower and unemployment 1.2% higher during that period.
In addition, if the tax cuts slated to expire at the end of 2010 are allowed to elapse, the personal income tax burden will increase by 25%, the highest point in history relative to GDP. There would be a 50% increase in statutory marginal rates for lower-income households and a 13% increase on the highest income households. The long-term capital gains rate will rise by one-third, from 15% to 20%. Dividend tax rates will nearly triple, increasing from 15% to almost 40%. Tax increases of this magnitude are likely to dampen both consumer spending and business investment.
Energy and climate change policies. Another challenge for the U.S. economic recovery stems from sharply rising inflation-adjusted energy prices. Gasoline prices per million Btu have risen 30% since 2005. Electricity prices for residential and industrial customers have increased more than 20% since 2001, reports the U.S. Department of Energy’s Energy Information Administration. Higher energy prices mean consumers and businesses have less to spend on non-energy goods and services, thus slowing overall recovery. Growth in demand for energy from developing countries is a major factor in global price increases. Of course, if U.S. policymakers would increase energy firms’ access to onshore and offshore areas with fossil fuels and promote more rapid development of nuclear power for electricity generation, U.S. consumers could have more energy at lower prices.
A Congressional bill mandating reductions in greenhouse gas (GHG) emissions also could impinge on economic recovery. Mandatory targets for GHG emissions will mean less energy used and slowed economic growth. A recent macroeconomic analysis by the American Council for Capital Formation and the National Association of Manufacturers of the Climate Security Act (S. 2191), introduced by Senators Joseph Lieberman (D-Connecticut) and John Warner (R-Virginia), shows that the bill would reduce U.S. GDP by about 1% in 2014 and by as much as 2.7% in 2030. GDP growth would slow under the bill because energy prices must rise sharply in order to force down U.S. GHG emissions. Net job growth slows, even after accounting for increases in employment in renewable energy; by 2020, employment would be as much as 1.8 million lower than under the baseline forecast.
Restoring strong U.S economic growth will be a long process this time around, especially with slowing productivity growth, the threat of higher taxes, persistently high energy prices and the economic impact of proposed federal climate policy legislation. Restoring strong economic performance will require U.S. policymakers to carefully balance fiscal, monetary and environmental policies to promote consumer confidence and business investment.
Margo Thorning, Ph.D., is senior vice president and chief economist for the American Council for Capital Formation.