By Scott J. Brown
October 31, 2011
Two clouds hung over the financial markets in the late summer: worries about a European financial crisis and concerns that the U.S. economy might be tipping back into recession. Real GDP rose at a 2.5% annual rate in the advance estimate for 3Q11, which should put to rest fears that the U.S. economy has already entered recession. However, there are still some important uncertainties in the growth outlook for 2012. European leaders dodged a bullet last week, with the agreement on Greek debt (failure would have triggered a more immediate crisis). However, they did not put a number of problems to bed completely. So, how long will the good feelings last?
The GDP data will be revised (and revised again), but the third quarter story is unlikely to change much. Consumer spending growth was moderate, better than was expected a month or two ago. Business fixed investment was strong, apparently fueled by robust growth in corporate profits. Inventories rose more slowly in the quarter, which creates the potential for a pickup in production in 4Q11. The strength in capital spending (expenditures for equipment and software rose at a 17.4% annual rate) suggests that regulations, worries about the federal debt ceiling, and anxieties about Europe have not been significant restraints at the corporate level.
However, consumer spending growth was fueled largely by a drop in the savings rate in 3Q11. Inflation-adjusted disposable income, a key driver of spending, fell at a 1.7% annual rate. Growth in nominal income was relatively strong in the first half of the year, but was offset by higher costs of food and energy. In 3Q11, nominal income growth slowed. Inflation cooled, but not enough to boost real incomes. A further rollback in prices could help in the remainder of the year and into early 2012, but we’re not there yet. Gasoline prices have fallen from the peak in early May, but the level remains moderately high and appears to be leveling off in the near term.
The key to the long-term consumer spending outlook is job growth. Most labor market indicators have remained consistent with moderate gains in the near term – a limited pace of job destruction, but continued restraint in hiring. Credit is gradually getting easier for small, newer firms. The monthly ADP estimate of private-sector payrolls has continued to show moderate job gains for small and medium-sized firms, but the pace is well below where it was in the early part of the year.
Studies of past financial crises point to some simple policy prescriptions. Hit back hard and early. Don’t wait for problems to become more ingrained. Global leaders and central bankers were relatively quick to respond to the subprime crisis three years ago. That doesn’t mean that everything was made okay. Rather, coordinated efforts prevented the crisis from getting a lot worse. Since that time, the record has been less than stellar. In the U.S., fiscal stimulus was much smaller than needed and poorly directed. Tax cuts (35% of the American Recovery and Reinvestment Act) did little to spur growth (but did add to the deficit). A third of the ARRA was aid to the states, which prevented bigger contractions in state and local government spending, but didn’t add much to overall growth. Less than a fifth of ARRA was infrastructure spending, which one would expect to provide most of the oomph. Granted, the recession was a lot worse than was expected during the heat of the battle, but “re-elect Obama, things could have been a lot worse” does not make a very compelling bumper sticker.
Still, treading water in the U.S. is better than the flat-footed policy response in Europe. Granted, there are plenty of austerity advocates in the U.S. In normal times, one could make the argument that reducing budget deficits helps to lower borrowing costs, boosting business investment and aiding the overall economy (that was the argument in the Clinton years). However, austerity in recessions is a terrible idea. Greece is a good example. Higher taxes and government spending cuts have weakened Greece’s economy, making debt problems worse instead of better. Nobody is arguing against reducing budget deficits in the long term. Certainly, European and U.S. budget deficits are on an unsustainable trajectory. However, too much belt tightening too soon risks dampening the recovery. The better policy is to try to boost growth.
Focused entirely on price stability, the European Central Bank raised short-term interest rates earlier this year, repeating the same mistake it made in 2008 (in comparison, Fed Chairman Bernanke recently spoke about making financial stability policy equal to monetary policy). On Tuesday, the ECB will have a new president, Mario Draghi, currently the head of the bank of Italy. However, the direction of the ECB is not expected to change – and typically, a new head of a central bank has to prove he is tough on inflation. The ECB is providing liquidity to the financial system as needed, but could do a lot more at this juncture.
The European debt agreement puts the major concerns about Greece off to the side for the present. However, it’s unclear exactly how much the European stabilization fund will be increased and how it will be financed. More troublesome, the agreement doesn’t do much to head off potential problems for Italy and Spain. The government debt situation in the UK is worse than in Spain and Italy, but borrowing costs for Spain and Italy are much higher. That’s because Spain and Italy do not have their own monetary policy. Recent research by Paul De Grauwe notes an inherent fragility in the monetary union. The ECB and the EU will have to address this at some point.
(c) Raymond James