The sharp gyrations in US equity markets have provoked new concerns that the US economy could experience a double dip.
There is not a direct correlation between the equity market and the economy. The stock market fell 36% during 1987 and real GDP grew by 4.1% during 1988. But the recent equity market turmoil came after a period in which economic data was clearly disappointing, so investors are very apprehensive.
In late July, the Commerce Department published revised estimates of GDP growth during the previous three years. The new data showed that real GDP fell by 5.1% during the 2008-09 recession rather than the 4.1% previously estimated. During the eight quarters of recovery starting in mid-2009, real GDP grew by only an average annualized rate of 2.4% compared to gains as large as 6-7% after previous severe recessions. The growth rate of the economy during the first half of 2011 was less than 1.0%. The weakness was broad-based. The strongest sector during the recovery has been exports. According to Credit Suisse, they are now 6.0% above their previous peak while imports are still slightly below their old peak. Consumer spending has increased by only 0.7% from its previous peak compared to an average of 13.6% during the recoveries from past severe recessions. Real residential investment is still 38.1% below its previous peak compared to a gain of 25.7% after past severe downturns. Real business fixed investment is also 12.1% below its former peak compared to a gain of 9.7% during previous recoveries from severe downturns. State and local government spending is 5.2% below its previous peak, but the Obama stimulus program has pushed federal spending 14.8% above the old peak.
The corporate sector slashed employment and boosted productivity during the downturn and early stages of recovery. As a result, profits have increased 28.5% from the previous peak. Labor compensation, by contrast, has increased only 3.1% compared to 33.1% during the recoveries from past severe downturns. The weak income growth has constrained consumer spending.
There are four arguments against a new recession starting during 2011.
First, the economy’s most cyclical sectors—housing, auto sales, business investment—are still below their previous peaks. They cannot decline vary far when they have failed to recover.
Secondly, interest rates remain at record lows. When the economy experienced a double dip in 1981, Federal Reserve policy was highly restrictive and real interest rates were nearly 8%. At the current time real interest rates are -1.5% compared to an average of 3.4% before the onset of previous recessions. Federal Reserve Chairman Ben Bernanke has now promised to restrain rates for another two years. The yield curve is also positively sloped whereas it is normally inverted before recessions.
Thirdly, the corporate sector is in a very healthy condition. Both profit margins and profits per worker are at record levels. The corporate sector has nearly $2 trillion of cash on its balance sheet. As a result, there is no pressure to lay off workers or trim capital investment. On the contrary, there will be 100% first-year depreciation allowances available for new equipment purchases through year end.
Fourthly, the household sector has begun to correct the balance sheet excesses which led to the slump during 2008. It has reduced debt by over $1 trillion. Household debt service payments have fallen from 14% of disposable income to 11.5%, or the lowest level since the mid-1990s.
Employment and retail sales data suggests that real GDP probably grew at a 2.5% annual rate during July. The great risk to growth persisting is now confidence itself. Investors perceive that policymakers no longer have any tools to stimulate the economy or are incapable of action. The Fed funds rate has been close to zero since 2008. Congress will be reluctant to pursue fiscal stimulus after the downgrade in the US credit rating. There will instead be significant fiscal drag during the year ahead as the tax cuts enacted last December expire and the Obama stimulus program unwinds. There will be a decline in federal aid to states which could lead to another 100,000 job losses. The recent stock market volatility has produced a large decline in consumer confidence, so there is a risk that households could curtail spending. This danger is magnified by the fact that the largest gains in consumer spending have been coming from high income people who are sensitive to wealth losses from the equity market. As consumer spending accounts for 71% of GDP, any serious downturn would drive the economy’s growth rate close to zero.
The White House and Congress must restore confidence by taking action to reverse the fiscal drag projected in 2012 while offering a credible plan for long-term deficit reduction. If they take such an action, the equity market would quickly rally to a new high.
The writer is chairman of David Hale Global Economics. His website can be found at www.davidhaleweb.com