I think everybody knows by now that the U.S. economy is in a full-fledged recession, probably the longest and deepest since the 1981-82 and 1973-75 recessions, possibly worse. This downturn began with the collapse of the housing sector several years ago, after an incredible boom and a housing asset price bubble. We have ente- red a major, probably secular decline in the levels and growth of consumer spending. That counts, because consumer spending in real terms represents 71 percent of the real GDP, and it is a major lever for the rest of the U.S. economy - as it is for the global economy, considering how much of what is exported to us is exported to the American consumer as the end buyer.
With declining sales profits and cash flow for American businesses, major cutbacks are being prepared as we speak for production inventories and jobs and in capital spending. There will be rising unemployment - 6.5 percent at the moment we speak, up to 8 percent in 2009, maybe a little more. (It would be even more, some 10-12 percent, if we didn’t have the demographics of the labor force in play that we actually have.)
That suggests there will be less consumption as a consequence, less sales, less earnings and business spending and worsening financial conditions for households and corporations, which in turn will lead to higher credit risk for financial institutions, already chock-full of credit risks and imploding at this point.
There is also a global recession. In part it comes from reductions in exports of many countries to the United States and to each other, and with lags that will take down the growth of U.S. exports and prolong our downturn.
And then there is the U.S. financial crisis. That crisis is about massive declines in asset prices, large contractions in the balance sheets and numbers of U.S. and global financial intermediaries, and an implosion of credit.
The consumer is at the heart of all this. Of course, housing and residential construction is still declining as well but that’s only some 3 percent of real GDP, while real consumption is, as I said, 71 percent of real GDP. It used to be 67 percent or so, then it got a bit higher, now it will regress again. This is both a secular and a cyclical adjustment.
Actually, consumer spending growth was far below its historical trend long before the 3 percent decline in the third quarter of 2008: it was already running at about 1.5 percent annualized. Which is not so much, considering that over the last 45 years, growth of consumer spending has been about 3.5 percent a year (adjusted for inflation). This is an incredible number that says something about our culture and what we do as consumers. Or rather what we used to do, since the current long-run and short-run indicators show a very dark picture. And a couple of them - the household financial position, job losses and an unemployment rate to come - suggest that the consumption downturn (3 in the third quarter 2008) will remain negative for two or three quarters.
I would add to this the psychological element. I think American consumers understand by now that the world has changed, that they can’t go on the way they have in the past. We’re going to have to spend less, borrow less, accumulate less debt, get our balance sheets in better shape. And we will have a much higher personal savings rate. The weak consumption will result in less growth in sales and earnings, and businesses will have to cut back.
The two areas of our economy I just mentioned add up to 84 percent of total real GDP. Think of what will happen to Chinese, South-Korean and Japanese exports when 84 percent of total U.S. demand is in decline. Of course, those countries also trade with one another, and yes, not all of them are as exposed to the U.S. decline as China, but they are nevertheless exposed. Some 27 countries have dropped into the recession by now, including the United States. That’s 80 percent of global output as we measure it, and I think it will be some 40 countries before we see the end of it.
If we now turn to the policy responses, these responses must come both on the monetary side and on the fiscal side. It is absolutely necessary to pour liquidity into the system. Of course we need lower interest rates, but once the illness is in train, lower interest rates can’t touch it. Even if they fall to zero, it wouldn’t help unless the rest of the system heals. Only once we start to pick up will low interest rates help.
The same goes for the liquidity that’s being pumped into the system, in the U.S. and other places, mostly focused on recapitalizing banks. There’s no way to prevent the private sector financial institutions, whose balance sheets are contracting as we speak, from swallowing the funds that come in, putting them into treasuries, shoring up their capital ratios – unless we reduce, which we ought to do, those capital ratiosduring this time of extremis. There’s no way to stop them from holding it, not lending to each other, and not putting it out to consumers and businesses. And when finally banks decide to do all that,we might discover something even worse: that nobody will want to borrow.
« American consumers under- stand by now that they can’t go on the way they have in the past."
Let’s turn to fiscal policy. We have a wave of fiscal stimulus packages in the U.S. and across the world, including increased government spending and other means of using the government in the private sector to shore it up. In the United States we see the government involved in the private sector, taking stakes on behalf of the shareholders or the stakeholders. That is very new, and I would rather see more incentives for the private sector to participate in putting money up rather than the government doing it; because as a consequence, our credit rating will probably get lowered by those credit-rating agencies which, if we reform our regulations right, will no longer be the hired hands of Wall Street.
The effect of fiscal stimulus and government spending in most cases helps; but it is transitory unless you keep doing it, and sooner or later you run into the problem of how to finance the deficits. Normally it’s with higher taxes, and we may go down that road. But the composition of this stimulus matters. Since the problem is the consumer, I tend to suggest tax cuts, permanent tax cuts, as a part of the stimulus, along with heavy-duty Keynesian government spending stimulus. And I tend to think that middle - and lower - income families should benefit most from it.
On the government spending side - you’ll hear this again and again in Washington - there’ll be a lot of infrastructure spending intelligently crafted for the short and long run. Part of the stimulus should go where it would be curative. Nothing we have done so far will really stop housing prices from falling. Neither the Paulson plan, the original one, which was going to help the balance sheets of banks, nor the current measures against foreclosures and bankruptcies, did do anything for the demand and supply of housing. I’m a free-market person, but I’ve suggested measures like in the 1930s, where the government goes into the housing business. The supply of all the vacant housing and the inventories of housing have to be squeezed down, while on the demand side, given that the consumer indicators will continue to go down, the cat will never catch its tail. If we let the deflation continue, if stock markets continue to do poorly, we will end up with a severe episode - not the 1930s, but the worst situation that we’ve had since the 1930s.