A Tale of Three Recessions

Last Friday, the Bureau of Economic Analysis released the 2009 Second Quarter GDP data. The latest information showed that the economy contracted by a 1.0% annualized rate and real personal consumption expenditures fell by an annualized 1.2%. To date, the current recession has seen peak-to-trough GDP decline by 3.9%. That is the largest decline of the post-World War II era.

The three biggest recessions during the post-World War II era are the 1973-75, 1981-82, and 2007-present recessions.



In the current recession, real personal consumption expenditures have fallen almost as much as they fell during the 1973-75 recession. With ongoing deleveraging and a rising unemployment rate, an additional decline is possible in the Third Quarter. In addition, real gross private domestic investment has plunged by 32.1% from its previous peak. That is the largest decline during the post-World War II period.



As noted earlier, household deleveraging is likely to place a lid on potential growth in personal consumption. The current recession differs markedly from the two earlier recessions cited above in that household and nonfinancial corporate leverage was substantially greater than it was during the 1973-75 and 1981-82 recessions.



The notably greater nonfinancial corporate debt could dampen a recovery in gross private domestic investment at a time when personal consumption is likely to play a smaller role in the upcoming recovery than in the recent past. In the 1973-75 and 1981-82 recessions, real personal consumption expenditures returned to their pre-recession peak two quarters after bottoming out.



This time around, a less robust recovery in real personal consumption expenditures is likely, even as real personal consumption expenditures accounted for a much larger share of real GDP than during the 1973-75 and 1981-82 recessions. It is plausible that it could take 3 or even 4 quarters from the bottom for real personal consumption expenditures to return to their earlier peak.

That means that gross private domestic investment, a reduction in the nation’s trade deficit, and increased government spending will need to lead the way to a sustainable economic recovery. However, the higher level of corporate indebtedness suggests that the recovery in gross private domestic investment will likely be a gradual one. Furthermore, given the high level of mortgage debt, the residential construction component of real gross private domestic investment, which has fallen 56.9% from its peak, is also likely to be slow. As a result of those two factors, the 1973-75 experience in which it took 8 quarters from its trough for real gross private domestic investment to return to its earlier peak is probably more likely than the 1981-82 experience in which it took just 4 quarters. An even lengthier recovery period is plausible.

A continued unwinding of the U.S. trade deficit should help strengthen the recovery, once it gets underway. However, the overall impact of this unwinding will likely be modest, if a global recovery pushes up the price of crude oil over the next 12-24 months.

Given the federal government’s unprecedented budget deficits, the recent massive expansion in federal spending is not likely to be sustained. Maintaining the aggressive fiscal posture could undermine investor confidence in the U.S. government, driving down the foreign exchange rate of the U.S. dollar, and generating a rise in long-term interest rates that could impede economic activity. In addition, with the IMF recently highlighting the medium-term fiscal challenges facing the U.S., namely the need to establish a credible fiscal consolidation strategy, efforts to curb the growth of federal expenditures could get underway in a year or two.

In sum, restrained growth in personal consumption, a slow recovery in gross private domestic investment, and limits to an expansionary fiscal posture will likely cap the rate at which the economy can grow. In turn, a slower growth trajectory could weaken revenue growth for the federal government, making it even more necessary for its developing and implementing a credible fiscal consolidation strategy. Given that challenge, it is quite likely that a combination of discretionary spending reductions and revenue increases will be deployed in any effort to cut the nation’s budget deficit. The extent of the tax hikes could have a material impact on economic growth.

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Flaws in Heath Care Bill Make Congressional Approval Prior to the August Recess Unlikely

When it comes to major health care reform, credible legislation will need to address the chronic situation at which national health expenditures have been rising faster than nominal GDP. The most recent CBO assessment provides no evidence of mechanisms or approaches that would produce such outcomes. Instead, the costs associated with H.R. 3200 (America’s Affordable Health Choices Act of 2009) would rise an average of 9.4% per year in the 2015-2019 period. That implies a national health environment in which expenditures continue to rise in excess of overall economic growth. In the long-run, such a situation is unsustainable.

Therefore, a closer look at the health expenditures problem is warranted. Since 1990, U.S. health expenditures have grown just over 30% more than the economy has expanded, mainly in two spurts.



Unless the growth in health care expenditures slows relative to overall economic growth, rising health costs will sustain or increase barriers to expanded coverage. At the same time, that development would raise federal health expenditures, particularly those associated with Medicare and Medicaid spending, faster than tax revenue can increase from the nation’s economic growth. In turn, that situation would increase the nation’s budget deficits and undermine its long-term fiscal situation.

Already, Congressional Budget Office (CBO) Director Douglas W. Elmendorf has told the Congress that the U.S. is on an unsustainable fiscal path in which its debt will grow faster than its economy. Rising health expenditures will play a leading role in that development. On July 16, 2009, Elmendorf told the Senate Budget Committee:

Under current law, the federal budget is on an unsustainable path—meaning that the federal debt will continue to grow much faster than the economy over the long run. Although great uncertainty surrounds long-term fiscal projections, rising costs for health care and the aging of the U.S. population will cause federal spending to increase rapidly under any plausible scenario for current law…

CBO projects that if current laws do not change, federal spending on Medicare and Medicaid combined will grow from roughly 5 percent of GDP today to almost 10 percent by 2035 and to more than 17 percent by 2080. That projection means that in 2080, without changes in policy, the federal government would be spending almost as much as a share of the economy, on just its two major health care programs as it has spent on all of its programs and services in recent years…

The large amounts of federal debt that would accumulate under each of CBO’s long-term budget scenarios imply that the government would have to spend increasing amounts to pay interest on that debt. The growth of debt would lead to a vicious cycle in which the government had to issue ever-larger amounts of debt in order to pay ever-higher interest charges. Eventually, the government would need to adopt some offsetting measures—such as cutting spending or increasing taxes—to break the cycle and put the federal budget on a sustainable path.

Therefore, while a popular fallacy has it that overall growth in health expenditures is largely a matter of consumer choice and, therefore, is not necessarily a bad thing, that assessment is a fundamental misdiagnosis of the situation.

In fact, it is little different from the notions advanced by those who championed increased access to mortgages, even as the nation’s housing bubble moved toward its crest. A persistent situation in which health expenditures increase at a rate faster than economic growth is a dangerous economic imbalance. Income from economic growth must be sufficient to pay for health expenditures. Therefore, maintaining a situation in which health expenditures rise faster than the economy grows is unsustainable in the long-run.

Such a situation would require foreign capital inflows to make up the difference. It is unlikely that foreigners would readily finance what would amount to a health expenditures bubble so to speak. Far from offering foreigners attractive returns on investment, such a situation would put the U.S at increased financial risk. Such increased risk would lead foreigners to demand higher returns to compensate them for assuming that risk. As a result, long-term interest rates in the U.S. would rise. Rising long-term rates would impede economic growth, leading to an even larger imbalance were health expenditures to continue to rise.

Ultimately, such a situation would end badly for the U.S. At some point, the U.S. fiscal risks would be too great and foreign capital inflows would cease or reverse. Confronted by such a situation, the U.S. would need to make wrenching policy choices, many of which would be bad. Crippling tax hikes that would suppress economic activity could be levied. Medicare could suddenly be transformed into a means-tested program, leaving a significant share of senior citizens to find alternatives that might not exist at the time. The federal government could create a health care office modeled after the World War II-era Office of Pricing Administration. That Office’s price controls would create shortages and major distortions in the health care sector. In desperate fiscal straits, the federal government could enact a law requiring the Federal Reserve to purchase long-term Treasury securities at a fixed low-interest rate or it could even partially default on its debt via its deliberately encouraging inflation.

Recent polling data suggests that Americans increasingly understand the need to address the health expenditures problem. A July 9-13, 2009 Ipsos/McClatchey poll found that if Americans had to choose between expanded coverage and cost restraint as their top priority, 44% chose reining in rising health costs. In a July 10-12, 2009 USA Today/Gallup poll, 52% selected curtailing rising costs.

In coming weeks, public pressure on account of the legislation’s failure to address the health expenditures issue, as well as its increasing the nation’s debt by $239 billion in the 2010-2019 timeframe, will likely lead Congress to slow down the consideration process. It is unlikely that Congress will approve such legislation before its August recess on account of its flaws and public concerns about rising health costs and the legislation’s budget impact. It is plausible that Congress may not pass such legislation at all this year.

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Will China's Central Bank Deploy Monetary Policy Against Asset Price Inflation?

On Saturday, Xia Bin, who heads the financial institute at the State Council Development and Research Center suggested that China’s central bank signal its commitment to a stable money supply in order to prevent an outbreak of asset price inflation. Xia’s call for a broader definition of the objectives of monetary policy is not new.

Since at least 1993, the International Monetary Fund (IMF) has argued that central banks should apply a broader definition to prices than the current consumption and production-based measures they currently employ. In 2000, Henry Kaufman, one of the United States’ leading private economists, wrote, “There is no mandate at the present time for any central bank to take into consideration financial asset prices explicitly in the formation of monetary policy. Nevertheless, the bubbling in the American financial market is an untenable situation.”

Arguments in favor of a broader set of price measures include:

• Capital flows that rush into assets are not picked up by conventional measures of inflation. In the past, sudden and signficant capital inflows have had a destabilizing macroeconomic impact and have precipitated a number of financial crises.

• Excessive asset price inflation can touch off a self-reinforcing situation in which an asset bubble develops.

• Asset bubble growth can crowd out saving. With asset prices rising rapidly, the “wealth effect,” can create disincentives for saving. In fact, that is what happened in the run-up of the recent U.S. housing bubble. Personal saving fell from 5.7% of disposable income in the First Quarter of 1995 to -0.7% of disposable income in the Third Quarter of 2005. Moreover, from the First Quarter of 2005 through the First Quarter of 2008, personal saving averaged just over 0.5% of disposable income.

• Reflecting the decline in personal saving was the onset of a “financial accelerator” effect. During the 1990s, personal consumption accounted for 67.5% of real GDP. During the 2000s, personal consumption had increased to 70.6% of real GDP. Since 2005, personal consumption has averaged 71.2% of real GDP. It was the rise in personal consumption that accounted for much of the growth in real GDP that occurred in the 2000-2007 period. During the 1990s, real GDP expanded an average of 3.1% per year. Non-consumption related items of real GDP rose 2.8% per year. In contrast, during the 2000-2007 timeframe, real GDP grew by 2.5% per year, but the non-consumption items increased by just 1.0% per year.

• All bubbles eventually collapse. When equities, commodities, or real estate bubbles pop, they can result in significant macroeconomic damage.

• Real estate bubbles are particularly hazardous given the amount of debt involved. The collapse of real estate bubbles can create financial system fragility, and frequently a financial sector crisis that can take years to heal. Such a crisis can lead to a severe credit crunch. In turn, the increasing grip of a credit crunch can produce a significant and prolonged recession. The ongoing synchronized global recessions provide an illustration of the dangers of a housing bubble.

The major issue involved in pursuing a broader definition of monetary policy concerns whether central banks can detect formative asset bubbles. In 1999, then Federal Reserve Chairman Alan Greenspan spoke on that issue. He explained that asset bubbles can lead to economic disruptions, but cautioned that they are very difficult to detect and that preempting asset bubbles would require the central bank’s making a judgment that runs counter to the collective decision making of millions of market participants. He stated:

History tells us that sharp abruptly, most often with little advance notice. These reversals can be self-reinforcing processes that can compress sizable adjustments into a very short time period. Panic market reactions are characterized by dramatic shifts in behavior to minimize short-term losses. Claims on far-distant future values are discounted to insignificance. What is so intriguing is that this type of behavior has characterized human interaction with little appreciable difference over the generations…

We can readily describe this process, but to date, economists have been unable to anticipate sharp reversals in confidence… To anticipate a bubble about to burst requires the forecast of a plunge in the prices of assets previously set by the judgments of millions of investors…

Chairman Greenspan’s concerns aside, history has provided a reasonably good guide that could be used as a starting point for determining when asset valuations are rising to levels that are disconnected from economic fundamentals. By indexing asset prices to growth in nominal GDP, a central bank could be alerted for situations where asset prices begin to sharply diverge from economic growth.

That has been the pattern with past asset bubbles. In the years leading to the 1929 stock market crash, stock prices (as measured by the Dow Jones Industrials) suddenly surged wildly higher relative to nominal economic growth.



The same pattern reasserted itself with respect to housing prices (as measured by the seasonally-adjusted Case-Shiller 10-city index, as that index goes back prior to 2000) and mortgage debt (home and multifamily residential mortgages).



In the case of the 1929 stock market crash, during 1927 stock valuations rose to 30% or more above cumulative growth in nominal GDP since 1922. By the end of the year, the Dow Jones Industrials’ increase was almost 60% above the level implied by nominal GDP growth.

With respect to the U.S. housing bubble, as indexed to 1995 valuations, mortgage debt reached that threshold in 2002 and housing prices attained that level a year later. In 2003, mortgage debt had grown more than 40% faster than nominal GDP and in 2004 home prices reached that figure.

What is clear in both cases is that asset valuations were rapidly diverging from economic growth. That is a signature of an “upward panic” or euphoria where market psychology increasingly trumps fundamental factors. In both cases, there was a 1½- to 2½-year window of notice that asset bubble formation was underway.

Perhaps tighter monetary policy might have cut short the expansion of the two asset bubbles. Perhaps the economic fallout in the wake of their premature collapse would have been less than ultimately resulted on account of their having been smaller than when they finally collapsed. That is all speculative.

What will be interesting is to see whether China’s central bank actually steers its monetary policy toward a more comprehensive objective that includes reducing the risk of asset price inflation. Even more important, it will be interesting to see whether that monetary policy approach proves effective in the longer-run.

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