Where Is the Economy Headed?
Sam Chandan Aug. 19, 2010, 3:26 p.m.
Aross the country, economists are being invited back to cocktail parties and summer barbecues. Even the dullest and most pedantic of my kind are finding themselves at the center of conversation. The pressing question to which we owe our elevated social status: Will we double dip? Reinforcing the importance of this inquiry, major stock indices fell sharply last week, sliding back from their recent highs as macroeconomic data dominated corporate earnings.
Investors of all stripes have cashed out recent gains in response to evidence that the economic recovery-in the United States and in the world’s other major economies-is losing its initial momentum. Driving the market’s swings, the unevenness of the recovery has required investors to internalize myriad conflicting signals from both data and from policy makers. In turn, this has fomented volatility in the prices of stocks, bonds, commodities and currencies, as well as in confidence that we will avoid falling back into recession.
Deep-seated reservations about the domestic and global economic outlook feed risk aversion in investment strategies. Over the past few weeks, this has been readily apparent in a flight to the perceived safe haven of the dollar. Over the longer course of the financial crisis, the same phenomenon has kept treasury rates at their remarkably low levels, offsetting wider risk premiums on a host of domestic investments.
The retreat from risky assets is not limited to the world of high finance. It has a parallel in the bricks-and-mortar world of commercial real estate, even if market imperfections limit our ability to observe these behaviors in the moment or with the same transparency. Just as persistent concerns about the growth outlook have pushed investors into treasuries and other government-backed securities, capital earmarked for real property has flowed into the most liquid markets, driving stronger pricing trends in a handful of coastal cities.
And so at least in the short term, economic uncertainty has fueled a capital and pricing differential benefiting markets like Manhattan and Washington, D.C. But this trend is not sustainable absent gains in economic activity and jobs; pricing cannot outpace fundamentals indefinitely, neither at the peak nor the trough of the cycle.
Economy Slows but Not All Things Are What They Appear
Is the economy sliding toward another recession? Or toward stagnation? The question is worth asking since even the most basic measures of activity show that the economy has slowed. According to the Bureau of Economic Analysis’ advance estimate, released July 30, real gross domestic product increased at an annualized rate of 2.4 percent in the second quarter. Following a modest expansion of activity in the third quarter of last year, growth accelerated to 5 percent in the fourth quarter before dropping off.
But the headline measures belie the complexity of the economy’s underlying growth drivers. In fact, each of the major domestic contributors to activity expanded in the second quarter. Personal consumption was relatively strong, slowing only slightly from the first to second quarters. It could have slowed more dramatically given mediocre income growth, constrained credit and the buffeting of job security by persistent unemployment. While consumer spending increased, a wide range of investment spending, in areas as varied as business equipment and housing, actually picked up over this period.
As for the slowdown in the headline G.D.P. numbers, the most significant drag on the economy in the second quarter was the widening trade deficit. Imports increased by 29 percent at a seasonally adjusted annual rate, almost three times faster than exports. If only American consumers’ appetites favored domestic goods and a lot less oil, the overall numbers would look a little better.
Of course, profits have been very strong at some firms. Much of the conflict between the macroeconomic view and the micro data on firm performance reflects differences in the ways and means of measurement. Macro data on the economy and the abysmal job reports tend to rely on serial seasonally adjusted comparisons of month-to-month or quarter-to-quarter changes.
On the other hand, the brighter company earnings reports compare current performance to a year ago. In early 2010, those have been easy comparisons to make. Large firms have dominated earnings increases, but revenue growth has lagged behind cost-cutting and productivity gains. All things being equal, this suggests that corporate profit growth will be more mixed in the coming quarters. Neither firm investment nor firm hiring show signs of lifting the economy to an upside surprise.
Among other key measures of the economy’s underlying trends and direction, gauges of sentiment and behavior are telling. While consumers and businesses are fickle in their assessments of the outlook, the readiness of each group to spend, invest or hire is a function of confidence, among other things. Because objective and quantifiable measurement of confidence is such a problematic exercise, discussions of sentiment are often treated as an afterthought.
But both groups show waning confidence in the recovery, and so the subjective measures cannot be ignored. The National Federation of Independent Business reported last week that small business confidence has slipped to its lowest level in four months. Consumer sentiment edged up in mid-August, according to last week’s update from Thomson Reuters and the University of Michigan. But the index is still only slightly higher than a year ago, when payroll employment was contracting at a troubling pace.
Downward Adjustments to the Outlook
The data that will allow a more conclusive determination of the economy’s direction in 2011-toward a double dip or some measure of growth-will emerge in the next few months. Until then, economists who claim to have a definitive insight into the exact outcome should be greeted with skepticism.
Conceding that the outlook has dimmed, however, the Federal Reserve has adjusted its projections and key policy positions. Its balance sheet will not contract as soon as originally envisioned. In its Aug. 10 statement, the Federal Open Markets Committee stated that “the pace of recovery in output and employment has slowed in recent months … [and] is likely to be more modest in the near term than had been anticipated.”
While it is too soon to make the call on the double dip, we are nearing a moment of clarity. If business confidence grows in a way that buoys private payroll growth, consumers will be better positioned to support the expansion. Jobs are a big part of the solution, for the economy and for commercial real estate fundamentals.
Take a New Road
As for what might spur private-sector hiring, there is considerable debate. On one side, proponents of further stimulus believe that further short-term measures will be critical, even if they exacerbate our long-term fiscal and monetary quagmires. Thinkers in this camp may point to the case of the United Kingdom, where austerity is being blamed for imperiling the nascent recovery. In an interview with the BBC last week, Alan Budd, who until earlier this month served as chairman of the new Office for Budget Responsibility within Her Majesty’s Treasury, indicated that a double dip is a possibility in Great Britain. This represents a reversal from the Britain’s strong start to the year.
There is a case to be made for further targeted stimulus. But at least as concerns the United States, I am not in the camp of those promoting a broad stimulus. We can certainly support families that have been deeply impacted by long-term unemployment. From a very subjective point of view, I would argue that we must do this. And I hope that the requisite social consensus will emerge.
But providing a tailored social safety net is not stimulus. Nor should it be. Rather, I would argue that we must abandon short-term stimulus strategies and adopt a radically different approach to encouraging private economic activity.
Rather than rely on public spending to kick-start the recovery, we must consider whether there is another reason for many businesses’ wariness in undertaking new investments and hiring. No one doubts U.S. policy makers’ and global debt markets’ willingness to support new stimulus initiatives in the short run. But I would argue that that is part of the problem.
The deeper uncertainty that inhibits the private sector reflects our unwillingness to address the long-term structural problems that beset our economy and that have rendered us less flexible and dynamic than in previous decades. Demonstrate the force of will to attack these problems, such as the deficit and the tax burden on small businesses, and do it without undercutting the incentives for entrepreneurship, and confidence in our long-term prospects may yet stave off a double dip.
Sam Chandan, Ph.D., is global chief economist and executive vice president of Real Capital Analytics and an adjunct professor of real estate at Wharton.