America May be in Its Own "Lost Decade"

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
June 21, 2011

IN THIS ISSUE:

1. Already Half Way Through a Lost Decade

2. Why is This Economic Recovery So Weak?

3. Where Does the Economy Go From Here?

4. The Debt Ceiling Battle Continues

Already Halfway Through a Lost Decade

When most people hear the term “Lost Decade,” they immediately think of Japan during the 1990s after it experienced its own financial crisis. The lost decade in Japan followed a bubble economy in the 1980s which saw stock real estate prices triple in that decade, but then it all collapsed. Japan’s economy went essentially nowhere for the next 10 years. Actually, Japan’s economy hasn’t done well in the 2000s either, so it is now often referred to as the “Lost Decades.”

When the US financial crisis occurred and the recession unfolded in 2008, hardly anyone predicted that America would face a lost decade. Traditionally, the American economy has recovered robustly from recessions as demand has been quickly renewed. Within a couple of years after the only two deep recessions of the post-World War II period (1974-75 and 1980-82), the economy was growing in the range of 5-6% or more, rates that seem inconceivable today.

Despite President Obama’s unprecedented $820+ billion stimulus package and historic quantitative easing by the Fed, the United States is now halfway into a lost decade, economically speaking. From the 1Q of 2006 to the 1Q of 2011, the US economic growth rate (GDP) averaged less than 1% a year.

During that same time, the share of the population working has fallen from 63.1% to 58.4%, resulting in the loss of more than 10 million jobs. Another 8.5 million are working part-time because they can’t find full-time employment. The number of Americans who are working today remains almost exactly at its recession low point, and the latest unemployment report for May suggests that growth is slowing once again.

Beyond the lack of jobs and incomes, an economy producing below its potential for a prolonged interval sacrifices its future. Huge numbers of new college graduates are moving back in with their parents because they have no job or means of support. Strapped school districts across the country are cutting out advanced courses and in some cases opening schools only four days a week.

On the political front, it does not appear that any material reduction in federal spending will occur until sometime in 2013, if at all. Back in August, Republicans were claiming that they cut $38.5 billion in federal spending, but then were advised by the CBO that only a paltry $352 million in spending cuts would happen this year, as I wrote in my April 19 E-Letter.

Now, as we face the impending debt ceiling fiasco in early August, the word increasingly leaking out of Washington is that lawmakers on both sides of the aisle are quietly negotiating to raise the debt limit by enough to get us through the 2012 presidential election. They want to kick the debt can down the road yet again and deal with it after the elections.

So, we could indeed be looking at a lost decade. Consider this: The federal budget for FY2013 will have been passed long before lawmakers come back to Washington in January 2013. If they in fact get serious about cutting spending, which is far from certain, they will be working on the FY2014 budget in 2013.

If federal spending is cut significantly at that time, it will initially have a negative effect on the economy – reduced federal spending means reduced federal jobs. So it is entirely possible that the US economy languishes for a couple more years afterward, and there we have the lost decade – 2006 to 2015. It could happen.

Why is This Economic Recovery So Weak?

As noted above, the two previous serious recessions in the post-WWII era (1974-75 and 1980-82) saw the economy roaring back with GDP growth of 5-6% or more within two years after the worst of the slowdowns. Economists and investors alike are trying to understand why the current recovery is so tepid and unemployment remains above 9%.

The worst of the latest recession occurred in the second half of 2008 and the 1Q of 2009 when GDP fell at an annual rate of -4.0%, -6.8% and -4.9% respectively in those three quarters. We are now more than two years out from the recession lows, and the best quarterly showing the economy has delivered was in 1Q 2010 when GDP increased at a 3.7% annual rate. Since then it has declined with GDP growing at the rate of only 1.8% in the 1Q of this year. Most analysts don’t expect the 2Q to be significantly better as I discuss below.

There are numerous theories as to why the economy is not recovering much faster. Some analysts, including your editor, believe that part of the reason the economy is not recovering faster is the fact that the Obama Administration is running trillion-dollar deficits, and most business owners know that this can only lead to higher taxes down the road. But that’s not the only reason this economic recovery is so disappointing.

Some investors are confused when they read that US productivity increased significantly during and after the recession. For example, non-farm business productivity increased by 3.8% in 2009 and 3.9% in 2010 according to the Labor Department. The manufacturing sector alone saw an increase in productivity of 5.9% in 2010.

How could this happen? Obviously, companies have found ways to increase production with fewer workers. As noted above, the economy has seen a loss of over 10 million jobs since the financial crisis and the recession began. Unfortunately, many of these jobs will never come back.

The May unemployment report noted that the number of “long-term unemployed” (those jobless for 27 weeks and over) increased by 361,000 last month to 6.2 million. The long-term unemployed make up 45.1% of all unemployed Americans, and this percentage is growing. The long-term unemployed are increasingly finding that they cannot get jobs doing what they did before the recession, as their skills have grown stale in many cases. These people are increasingly being forced to take lower paying jobs or part-time work.

Continued high levels of unemployment are also taking a toll on consumer confidence and spending. The Consumer Confidence Index plunged from 66.0 in April to 60.8 in May. The University of Michigan Consumer Sentiment Index fell from 74.3 in May to 71.8 in the first half of June. These reports show that consumers are considerably more apprehensive about future business and labor market conditions as well as their income prospects.

Economic Confidence Index by Week, 2010 and 2011

The deterioration in the jobs outlook and six straight weeks of Wall Street declines sent Americans’ confidence in the US economy plunging to an average of -35 during the week ending June 12, a decline of nine percentage points from two weeks earlier , and six points worse than it was in the same week a year ago. Economic confidence is now approaching a 2011 weekly low as noted in the chart above.

Economic confidence reached its peak so far this year at -18 in February and then generally declined through the week ending April 24, when it reached -39 as gas prices surged and economic activity slowed. Economic confidence improved to -25 during the week after Osama bin Laden’s death. However, Americans have since become more pessimistic about the economy in early June, with confidence reverting to late April levels.

All of this has a negative effect on consumer spending. As the chart below illustrates, Consumers remain more interested in paying down their debts as opposed to taking on more of it, and that trend is not likely to change soon. The chart tracks private debt held by households and businesses. Total private sector debt held by consumers and businesses combined peaked at 283% of gross domestic product in early 2008 - nearly three times the size of the entire economy.

Private Debt as a Percentage of GDP

As you can see above, consumers and private businesses began to aggressively deleverage in the wake of the financial crisis and the recession by paying off debt and saving more. Private debt fell to 234% of GDP by the end of last year, though much of that decline resulted from bad mortgage debt shifting from banks to the government through the bailout of mortgage finance giants Fannie Mae and Freddie Mac.

Notice also how this trend of deleveraging accelerated sharply in late 2009 and 2010. The question is, how long will this continue? Carmen Reinhart, the co-author of the very popular book, This Time is Different: Eight Centuries of Financial Folly, puts it this way:

“I think we’re in for a lot of disappointment. If historic norms hold, deleveraging isn't pretty, and it is not a smooth process. We're already four years into this. I don't think the next six years look great."

Obviously, Ms. Reinhart believes that the deleveraging trend will continue and notes that households still can't afford the current debt levels, which are well above the average disposable income.

Where Does the Economy Go From Here?

For all the reasons noted above, and others, this recovery is very slow as compared to those following the last two serious recessions. And it’s likely to remain sub-par for some time to come. Most of my best sources now believe that GDP will grow at an annual rate above 2% in the second half of this year (as compared to only 1.8% in the 1Q), but most also agree that it will have trouble rising above 3% later this year.

Regular readers know that I subscribe to Blue Chip Economic Indicators (BCEI), along with many other services. BCEI produces a monthly report wherein it surveys the opinions of 50 leading economists and forecasters. I will volunteer that the so-called “50 leading economists” tend to be a bit on the optimistic side, as compared to most of the more expensive publications I read. Nevertheless, their monthly survey results are helpful in keeping track of what mainstream forecasters are expecting.

The latest BCEI survey didn’t hold any big surprises. As expected, the economists (on average) dialed back their forecasts from last month. The BCEI average estimate of 2Q GDP growth was downgraded to 2.6% from 3.2% a month earlier. I should point out that this survey was taken just days before the surprisingly negative unemployment report on June 3, so I wouldn’t be surprised to see another downgrade below 2.6% next month.

As for the second half of this year, the average GDP growth estimates were 3.3% in the 3Q and 3.4% in the 4Q. If the numbers above prove accurate, that would mean GDP growth of 2.78% on average for all of 2011. For 2012, the survey average was for GDP growth of 3.0% in the first half and 3.2% in the second half of next year.

There is a broad consensus among economists that the economy has to be growing by at least 3% just to absorb the apprx. 150,000 new workers which come into the workforce every month. Likewise, most agree that it will take growth of at least 4-5% over an extended period to whittle down the unemployment rate.

On that note, only two out of the 50 economists surveyed by BCEI predict growth of 4% or better in 2012. On the other hand, 19 of the 50 economists predict GDP growth to average less than 3% next year. Again, this group tends to err on the optimistic side.

While it remains to be seen what the US economy actually does over the next year and a half, the forecasts discussed above do not paint a pretty picture for President Obama. As noted, only two of the 50 economists surveyed believe the economy will be growing at 4% or above by election day in 2012. Likewise, it looks like the unemployment rate will still be well above 8% by that same time. This does not bode well for Obama’s re-election, but then again, the field of Republican hopefuls leaves a lot to be desired.

On that note, I am getting a lot of questions from readers who ask if I know whether Texas Governor Rick Perry will enter the race. The simple answer is, I do not know. However, the recent defections of Newt Gingrich’s senior political staffers, two of whom are long-time political aides to Governor Perry, makes a Perry run all the more likely.

Dave Carney, who had been Perry’s lead political consultant for years before joining Gingrich, is now reportedly in Austin working for Perry again. Rob Johnson, who was Perry’s campaign manager in the last gubernatorial election, also bolted from the Gingrich staff at the same time and is reportedly now working for Perry again. Coincidence? I doubt it.

Most of us on the right in Texas don’t consider Perry to be a true conservative, plus he’s got some baggage (including flip-flops). Of course, everyone else in the GOP field has baggage as well. I will give Perry this: he is a terrific campaigner. If he and his handlers believe he can win, I think his ego will make him get in.

Let me make one point abundantly clear: While Governor Perry is not as conservative as I might like, I would vote for him in a heartbeat over President Obama!

The Debt Ceiling Battle Continues

Since I veered onto a political note just above, let’s revisit the issue of the debt ceiling. Vice President Biden and a bipartisan group of congressional leaders have been meeting for several weeks to reach a compromise on raising the debt ceiling. According to Treasury Secretary Geithner, the government will have exhausted all of its borrowing authority on August 2. Currently, the plan is to get an agreement done before July 4 when Congress goes on its summer recess.

For the last couple of weeks, Biden has said he felt confident that an agreement could be reached by the end of June that could be sent to the House and Senate for a vote. As I discussed last month, there is little doubt that a deal will get done, although there may be a few meaningless fireworks just ahead. The final deal will almost certainly fall far short of what the Republicans are demanding in terms of spending cuts. Count on it.

The Republicans have two basic demands: 1) that spending cuts must exceed the amount by which the debt ceiling is raised; and 2) that there must be some spending cuts to entitlement programs. The Democrats are pushing for some tax increases to raise federal revenues, and they refuse to cut any entitlement programs. Biden’s confidence that a deal can be reached by the end of June may be wishful thinking.

Last week, Washington was rife with rumors of an agreement being hammered out by Biden and the six top congressional leaders entailing roughly $2.5 trillion in promised spending cuts that are to materialize or accrue in future decades in exchange for a $2.5 trillion increase in the government’s credit limit.

That would be a bad deal because it would not include a Balanced Budget Amendment that would bind future Congresses. The spending reductions could be easily undone, after the next election, in fact. It also means we would be passing up the chance to reduce current-year spending or repeal ObamaCare.

We’ve seen this movie before. Bipartisan summits in 1983, 1990, and 1997 all proved ultimately unfriendly for taxpayers but were great for the Washington spending class. Taxes went up, and the promised spending cuts never materialized or were later reversed.

In any event, it is not at all clear what will happen just ahead. Speaking on the CBS “Face The Nation” program on Sunday, Senate Minority Leader Mitch McConnell stated: “If we can’t do something really significant about the debt ceiling, then we’ll probably end up with a very short- term proposal over a few months, and we’ll be back having the same discussion in the fall.”

This carefully placed statement suggests that both sides are still far apart on reaching an agreement, and that the Republicans are prepared to essentially walk away from the talks and settle for a short-term increase in the debt limit. So it remains to be seen what will actually happen, but I continue to predict that some kind of deal will be made just ahead.

As discussed in my May 24 E-Letter, the Treasury Department has borrowed large sums of money from various government agencies and trust funds to keep the government afloat since the official debt ceiling was reached in May. As I noted last month, all of that money has to be repaid as soon as the debt ceiling is increased.

So just how much money do you think the Treasury has to borrow as soon as the debt ceiling is increased? $100 billion? $200 billion? $300 billion? Nope. They announced last week that the Treasury will have to borrow a minimum of $600 billion as soon as the debt ceiling is expanded. Wow!

To put that in perspective, the previous largest monthly deficit ever incurred was $222.5 billion in March of this year. That eclipsed the previous largest monthly deficit of $220.9 billion in February.

And finally, let’s not forget that the Federal Reserve will end its QE2 Treasury bond purchases by the end of this month. The 10-year Treasury bond yield has fallen from around 3.5% to near 3% over the last month or so due in part to new signs that the economy is slowing down. But I would not want to be long T-bonds when the Treasury starts borrowing $600 billion just ahead. Expect some wild financial markets when that happens.

I could go on and on with that discussion, but it’s time to hit the send button. Central and south Texas are having one of the hottest and driest Junes on record. Temps here in Austin have been over 100 degrees almost every day in June, and Lake Travis where we live is dropping every day.

Hoping it’s cooler where you are,

Gary D. Halbert

SPECIAL ARTICLES:

“Lost Decade” for many American cities
http://www.investmentnews.com/article/20110620/FREE/110629998

US credit rating at risk if debt ceiling is not raised
http://www.kansascity.com/2011/06/19/2961583/congress-debates-raising-us-debt.html

Debt ceiling: Time’s Running Out
http://money.cnn.com/2011/06/19/news/economy/debt_ceiling/?section=money_latest