Today, John Williams, the President of the San Francisco Fed gave a very interesting speech. Here are some of his key points. I respond after each quote.
"There is no question that we are currently on an unsustainable long-run path of federal fiscal deficits. It is essential that budget deficits over the next decade be brought under control. The costs of not doing so are enormous.
"First, uncertainty about future fiscal policy and doubts about whether Uncle Sam will pay his bills are likely damping consumer and business confidence. Second, heavy government borrowing pushes up interest rates for businesses and consumers, which tends to reduce capital spending and long-term productivity. That’s a recipe for long-run economic decline and lower American living standards.
"Sooner or later, we’ll have to deal with the deficit, and we should get our house in order sooner rather than later. Finally, the lessons from the events in Europe are clear—unsustainable deficits can cascade into a crisis. If that happens, policy options are limited and the damage to the economy can be severe."
I fully agree that we need a long-term plan to get the deficit under control. I would point out that current law, if left unchanged, would put a serious dent in the deficit. That would, however, mean the repeal of all of the Bush tax cuts and no more patches to the Alternative Minimum Tax. Not fun, but not the end of the world either.
So far there has been little to no evidence in the market that “crowding out” is happening due to heavy government borrowing. Long-term interest rates are near historic lows, but there is no guarantee that they will always be so low.
"I need to stress, even as the nation must come to terms with its fiscal problems, a federal default must be avoided. Make no mistake — the Federal Reserve doesn’t have a magic wand that will allow the economy to get through a crisis of this magnitude unscathed. Fortunately, the key players in Washington seem to understand the risks, which may be why financial markets have stayed reasonably calm — at least so far."
The key players on paper are not the same as the actual key players, and not all of the actual key players — most notably the Tea Party-backed freshmen in the House — seem to understand the risks. I agree that monetary policy has already done a lot to help keep the economy afloat, but with unemployment very high and inflation low, I think another round of Quantitative Easing would be helpful.
"Since the middle of 2009, the economy has been steadily growing. That’s no small accomplishment when you consider that less than three years ago we lived through the most severe financial crisis since the Great Depression. The critical question is why the recovery has been stuck in second gear.
"In particular, the pace of growth has been insufficient to make much of a dent in unemployment. During the downturn, we lost nearly 9 million jobs outside the farm sector. Since job growth resumed, payrolls have expanded by less than 2 million jobs.
"Moreover, the pace at which we’re creating new jobs has slowed to a crawl. In May and June, we added on average just over 20,000 jobs per month. Not only are 14 million people unemployed, but about 45 percent of them have been out of work for six months or more, a sobering reminder of how deep and prolonged this downturn has been."
Unemployment is the real crisis, not the short-term deficit. Why can’t anyone, Republican or Democrat, in Congress or in the White House seem to understand this? If we can get higher growth we will have lower unemployment. That will lead to higher tax revenues and a lower deficit. Adding 20,000 jobs a month does not even come close to keeping up with population growth, let alone re-employing the 14 million.
“Fortunately, some of the disappointing performance this year reflects events that should have only a transitory influence on the economy. These included unusually destructive weather — virtual plagues, if you will, of blizzards, tornadoes and floods. Then there was Japan’s disaster, which caused supply-chain disruptions in several industries, especially autos.
"Probably the biggest blow came from the spike in energy costs, which undermined confidence and damped consumer spending. All the same, the main effect of high energy prices on the economy’s rate of growth should prove temporary. Consumers have had to reduce their spending on non-energy goods and services.
"But if energy prices hold steady, households don’t have to keep cutting their spending by more and more. In fact, oil prices have fallen substantially since April on net, which means more income is available for discretionary purchases.”
Yes there are temporary headwinds that will abate, but new ones will crop up. The price being demanded for raising the debt ceiling is massive spending cuts. Those spending cuts will further slow the economy and add to the ranks of the unemployed. There are also many factors that have been slowing the economy and which will continue to do so.
“One of the most important currents holding back recovery has been housing. The collapse of the housing market touched off the financial crisis and recession. In most recessions, housing construction falls sharply, but then leads the economy back when growth resumes. As you well know, that snapback hasn’t occurred this time.
"Before the crisis, residential investment as a share of the economy was at its highest level since the Korean War. Today, housing construction remains moribund and residential investment as a share of the economy has fallen to its lowest level since World War II.
"On one level, that’s not surprising. We simply built too many — in fact, millions too many — houses during the boom and we are still feeling the effects of this overhang.
"Consider housing prices. From their peak in 2006 until early 2009, home prices nationwide fell by nearly a third. When you exclude distressed sales, prices appeared to bottom out in 2009 and early 2010. New housing starts also appeared to stabilize in 2009, after plummeting some 75 percent during the housing crash.”
I agree with most of this, but I am not sure that the slide in housing prices is over. We have seen an uptick in apartment construction, but not much of one in single-family housing.
“The $64,000 question is when will the housing market finally recover? One daunting challenge for such a recovery is the huge number of homes in foreclosure. Almost 7 million homes have entered into foreclosure since the first quarter of 2008 and some 2 million are still in the foreclosure process.
"In addition, there is a shadow inventory of homes currently owned by delinquent borrowers. When you add up unsold new houses left over from the boom, homes for sale by owners, foreclosed residences for sale by lenders, and the shadow inventory of houses at risk of distressed sale, you come up with a massive supply overhang.
"Over time, more reasonable prices and an improving economy ought to bring buyers off the sidelines and set the stage for recovery. But high unemployment and anemic wage gains are leaving people worried about their income prospects and cautious about buying homes. Also, the dramatic plunge in home valuations since 2006 has made some first-time homebuyers wary about entering the market because of worries that prices might fall further.”
He needs to move the decimal point a few places, more like the $640 billion question. Slow housing is depressing the economy, and housing will not recover until the economy improves. Chicken, meet Mr. Egg; Egg, say hello to Mr. Chicken.
“A second current we’ve been swimming against is tight credit conditions. Let’s take small business, for example. It’s harder today for small businesses to get credit and some of the reasons aren’t immediately obvious. The usual image of the small business owner is the man or woman who goes to a Main Street bank looking for a loan. However, it turns out that small businesses depend indirectly on global capital markets for funding.”
In addition, historically many start ups depended on the founders using the equity in their houses as the collateral for loans to fund the start up. If the house is underwater, no loan. We lost almost $8 trillion in housing wealth in the housing crash. That leaves a very big mark when it comes to collateral for start-up firms.
“Credit is far from the only factor keeping consumers and businesses in check. The weak job market and slow income growth limit what households have to spend. At the same time, households have been trying to repair their finances after years of taking on too much debt and setting aside too little in savings.
"Americans have come to realize the dangers of running up debt and they’ve rediscovered thrift. A key impetus has been rebuilding wealth lost when house prices collapsed and the stock market tanked.”
On an individual level, thrift is a good thing, but when everyone decides to get thrift at the same time, it is a very bad thing. It just ends up throwing more people out of work, and it is hard to increase your savings when you are out of work. This is what Keynes referred to as the “Paradox of Thrift.”
“One other current I should mention is government. Local, state and now the federal government are aggressively cutting spending to balance budgets or trim deficits. Total government employment is down by almost half a million since the recovery began. Budget reform is good medicine for the long run. But, in the short run, government belt-tightening means that the private sector will have to do even more to keep the recovery on track.”
Spending cuts mean less demand, less demand means fewer customers. Why will businesses add employees or more plant and equipment if there are not going to be the customers? Yes, the private sector will have to do more to keep the recovery on track — but will they?
Barring the debt-ceiling fiasco getting even worse from here, we will probably manage to avoid an actual new recession in the second half or early 2012. However, growth forecasts will probably have to be revised lower.
It is not clear to me that the removal of the current temporary restraints on growth, bad weather, high energy prices and the Japan situation will have that much bigger of a positive effect on growth than the new problems will have on the negative side. The Fed was easing in the first half with QE2 and is now sitting on the sidelines. That is a positive factor that is getting removed.
There is no guarantee that the weather is going to get all that much better, and oil prices could well start to rise again. We don’t know yet just how big the spending cuts are going to be, and how much they will be front-end loaded.
The more cuts we have in the short term, the weaker growth is going to be. At this point, an acceleration to more than 2.5% growth in the second half seems very optimistic. Overall growth in the second half appears to me to look much like the growth in the first half: anemic.
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