Businomics Blog

The Composition of the Economy: It's Not What You Think

Yesterday I heard a doom and gloom outlook from a businessman whose attitude derived the weak commercial real estate market.  I regularly hear from residential real estate brokers and developers that the economy is terrible, terrible, terrible.  And if the stock market has had a bad day, everyone who follows his investments too closely thinks that the economy is lousy.

As an economist, my job is to have perspective on all of this.  That is fairly easy to do if you keep in mind the composition of the economy.  Here it is (excluding inventory changes and net exports, because it's hard to put negative numbers into a pie chart):

Look at the two smallest wedges of the pie: residential and non-residential construction.  That's why I'm not terribly pessimistic about the overall economy, despite being pessimistic about the near-term outlook for these two sectors.  They are small.

What's big?  The consumer service sector.  Also consumer non-durables, which includes food eaten at home, clothing and gasoline.  These are not only big sectors, they are fairly stable sectors.

My greatest frustration as an economic forecaster is listening to the "factoid economists," people without a good grasp of the whole, who seize on anecdotes here and there, extrapolating from small sectors to the overall economy.  My advice: spend a little time with the numbers.  The whole GDP accounts (including the revisions released today) are available at the BEA website.

Will Unemployment Prevent Recovery From the Recession?

One question I get in my speeches goes like this:

Won't our high unemployment rate prevent an end to the recession?  After all, people out of work don't spend much money.

Think about this a moment.  How did we ever get out of the recession of the early 1980s, when unemployment rose well above 10 percent?

Or how did we get out of the mid-1970s recession, when unemployment rose to nine percent?  In a few years it had fallen beneath six percent.  How did that happen?

It turns out that the economy has some self-correcting features in it.  Also, policy may help extract us from recession.  The self-correcting features include--believe it or not--consumer spending.  The drop in consumer spending has been disproportionate to the decline in incomes.  That is, most of the drop was due to employed people who were scared, rather than unemployed people.  When the employed people realize that they have dodged the bullet, they start spending.  So the key factor isn't so much the behavior of people out of work, but the behavior of those who still have their jobs.

Inventories also help correct the economy.  Businesses have cut back on their inventories, forcing producers to cut back on their output.  When businesses simply level out their spending, the economy will be relieved of a major negative.

One other self-equilibrating factor will not be at work this recovery.  In recessions, interest rates typically fall, stimulating new housing construction.  However, our excess housing inventory will prevent that from working this time round.

One last comment on unemployment:  look carefully at the historic pattern and you'll see that the unemployment rate is a lagging indicator, meaning that it starts to improve after the overall economy is already improving.  As such, it does not prevent the economy from improving.

If high unemployment prevented a recovery from recession, then we never would have recovered from our first recession.  But we've recovered from it, and from every other recession.

There are plenty of things to worry about.  The high unemployment rate preventing a recovery is not one of those things.

Bailout! A New Merle Hazard Song

My day is always happy when Merle Hazard releases a new song. (Hat tip to Calculated Risk.)  Here's his latest, Bailout:

You can find more at www.MerleHazard.com.  My favorite is "Inflation or Deflation."

Business Loans Continue to Decline--But Due to a Credit Crunch?

Bank loans to businesses for commercial and industrial (C&I) purposes continue to decline.  That by itself does not prove that we are in a credit crunch.

Credit crunch definition:  "When credit is rationed by non-price means in a way not typical for that type of credit at that time of the business cycle."  My definition excludes tightening of credit simply by raising interest rates, and it also excludes the tightening of credit that is normal during recessions.  The concept we're trying to get at is abnormal tightness.

Do we have that now?  Here's a picture of C&I loans outstanding by banks.  For each of the past 10 business cycles, I measure the dollar value of loans outstanding divided by the value of loans outstanding at the time when the business cycle was at its peak.  So a value of 1.2 on the chart says that loan volume is 20 percent higher than it was when the business cycle hit its peak.

Three observations:

1) In the latest cycle, loan volume grew surprisingly fast in the early months.  Maybe NBER's Business Cycle Dating Committee has the cyclical peak wrong.

2) There seems to have been a little blip up in October of last year, probably caused by borrowers who were closed out of the commercial paper market exercising their standby lines of credit.

3) Loan demand is usually soft in a recession and immediately following.  That makes sense given what we know about inventories and capital spending, the two main triggers of C&I loans.

So are we in a credit crunch?  I think not.  It's simply garden variety credit tightening combined with weak demand for loans.

(Note that this discussion does NOT include consumer loans or real estate loans.)

How does credit availability affect the economic forecast?  I think that business demand for credit will be soft for its own reasons, but limited even more by normal bank behavior of tightening credit standards in the wake of a recession.

How Strong Will the Recovery Be?

I'll be updating my economic forecast in early August, taking a little longer than usual because of a major revision in the GDP statistics and their underlying components.  (Data wonks read this.)  However, it's never too soon to think about the strengths and weaknesses of the recovery.  Before getting into that, though, let's look at a chart that comes courtesy of David Altig of Macroblog:

It took me a minute to figure it out.  The horizontal axis of the chart shows the depth of the recession.  The vertical axis shows the strength of the recovery.  The points within the red circle are historic data for past recessions.  The points within the blue circle are predicted values from the Blue Chip Economic Indicators survey.

Look at how this historical data tend to fit along an upward-sloping trend.  Because the two axes use different scales, it may not be apparent that the line of best fit is pretty steep.  By eyeball, recessions with a two percentage point drop in GDP are usually followed by a six percent gain in GDP.

Now look at the Blue Chip consensus.  Even the most optimistic forecasters are much more pessimistic than historical experience.  (But that's OK--it's quite possible that we will expand the envelope of historical experience here.)

For the record, my current (meaning old) forecast has 2.8% growth of GDP in the four quarters that begin the recovery, so I'm more optimistic than average, but less optimistic than the 10 biggest optimists.  I'm also more pessimistic than historic average experience.

Now let's do the conceptual tally:

Factors leading to an economic recovery:

The high savings rate has put money into consumers' pockets
Monetary stimulus has been very strong
Inventories will swing from negative to positive forces
The weak sectors, such as housing construction, can't get much worse

Factors that will limit the strength of the recovery:
The residential construction sector will not rebound, because of excess supply
Consumers will be moderate in their spending rebound
Credit limitations will limit some business and consumer spending
Uncertainty about government policy will trigger delays in spending decisions

How will tax hikes and the deficit affect the economy?
Tax hikes will have negative effects in the short run, but my reading of economic history is that they do not trash the economy in the short run.  They will limit our growth by a bit, which will accumulate like compound interest (but with a negative effect rather than a positive effect) over time.  I don't expect the deficit per se to have a big effect, except that it will trigger tax increases.

Will inflation accelerate in 2010?
There will certainly be some inflation acceleration in my economic forecast, but nothing like the early 1980s.  That's because I think the Federal Reserve will begin tightening next year.  But keep your fingers crossed.

Question for readers:  What other items should I report to you when I complete my forecast?  Leave a comment.

Selling in the Recession: Tips for Speakers and Consultants

Earlier this week I spoke to the National Speakers Association annual convention about how the recession was impacting the speaking business, and more importantly, how it was changing the needs that our clients have.  For example, many companies feel that they don't need "sale training" right now, because after downsizing, their sales force consists of the most productive sales people.  However, the customers who are shopping today are not the same as the customers who bought a few years ago.  Today's buyer is a value driven customer shopping for bargains.  The sales skills that worked for the aspirational buyer in the boom don't work on this buyer.  So sales training is needed, but not the same stuff.  What companies need is training specific to the changes caused by the recession.

It's not just about sale training.  It's harder to lead today's workers, because they are so fearful and stressed about their personal financial risks.  Companies won't buy the same old leadership seminars, but they might buy a program that helps their line managers get greater productivity from the stressed-out employees.

Motivational speakers are down in the dumps about weak bookings, but motivation is needed now more than ever.  I suggested that they not only motivate their audiences, but also teach how to motivate subordinates, colleagues--and perhaps even bosses.

Here's my PowerPoint deck.  NSA members will soon be able to purchase an audio recording of the session.

Financial Storm, Economic Rainbow: Find the Gold in the Recovery

View more presentations from Bill Conerly.

Economy: Step Onto My Cloud

Just installed a cool little Firefox application called Cloudlet.  Here's what happened when I googled myself:

Question: if you know me or my work, what other tags should Google have found?  Leave a comment.

Housing Starts Still Weak, Despite the Headlines

These guys who write newspaper headlines are getting me down.  Here's the Wall Street Journal's online head:  "Housing Starts Jumped in June."

Bloomberg proclaims: "Housing Starts in U.S. Unexpectedly Climb to Highest Level in Seven Months"

The Christian Science Monitor says:"US home construction recovering."

With that preparation, take a look at the latest data:

Wow!  Isn't that a real jump, a real recovery.  Ho hum.

What Do Inventories Mean for the Economic Forecast?

Businesses cut inventories again, according to the latest data released here.  Inventory swings are tremendously destabilizing.  I'm actually kind of proud of the explanation of this that I wrote in Businomics.  (If you are adamant not to buy the book, take a look through Amazon's Look Inside feature, searching for the phrase "Magnified Effects on the Supply Chain.")

The latest data show the stark decline in inventory levels:

Here's a simple example of how bad this is.  A store used to sell, before the recession, 400 shirts per month.  Now they only sell 300 shirts per month.  So they might cut their monthly order with the shirt manufacturer by 25%.  However, if they are not only selling fewer shirts, but desiring to stock fewer shirts in inventory, they will not order 300 shirts, but maybe only 240.  Their 25% drop in sales has translated to a 40% drop in orders.  No wonder manufacturers are hurting.

When sales turn up, however, this will work to the economy's benefit.  Stores will not only sell more shirts, but decide to stock higher inventories.  At that point in time, each dollar that you spend will trigger more than one dollar of production.

How close are we to an economic turnaround thanks to the inventory swing?  Here's an historic perspective on inventories:

Past inventory rebounds have not been "V-shaped" but more "plate shaped."  For some months it will appear to be "L-shaped."  However, the economy will get a significant boost when inventories simply level off.  In the first quarter, flat inventories would have led to only half the GDP decline that we actually saw.  But do not expect a sharp upturn in the economy because of the inventory swing, at least not in the next few quarters.

A Good Leading Indicator: Intial Claims for Unemployment Insurance

No leading indicator is perfect, but initial claims for unemployment insurance is fairly good.  Here's the latest chart (data available here):

It looks like the worst is behind us, but that the improvement has been very, very mild.  In other words, consistent with much of the other data coming out.  So I expect things to get better, but at a very gradual pace.

The rest of this post is about data issues, which most readers will want to skip.

Why is initial claims the better leading indicator than total claims?  First, historical evidence.  You look back for several decades and you can clearly see that this series tends to lead the contemporaneous measures of the economy. 

Second, initial claims is a more consistent series than total claims.  Total claims is affected by changes in rules regarding the total duration of benefit eligibility.  In most states, 26 weeks is the maximum period of time that you can collect UI.  But there are automatic triggers that can extend the maximum to 39 weeks.  (The triggers involve a high and rising unemployment rate.)  In addition to these automatic triggers, Congress enacts a special extension of benefits most recessions.  Why does Congress do this if there is already an automatic trigger?  Because it enable Congress to say that they've done something.  The bottom line is that total claims is based on less consistent rules than initial claims.

However, anyone comparing today's level of initial claims with historic data should be aware of two issues.  One is that we have a larger labor force today than in past cycels.  Mark Perry over at Carpe Diem blog has adjusted the data; here's his latest look.

The second issue is that rules for UI eligibility have broadened over time, and especially this year.  It's complicated arithmetic dealing with this issue: to be eligible, you have to have earned a certain amount in the past year.  The old way of calculating this involved a long time lag, due to paper records taking a long time to evaluate.  The new way involves a much shorter time lag, which is enabled by electronic technology.  However, it increases the number of people eligible for UI, particularly among those with only six to 12 months of work experience.  As a result, initial claims are today higher than it would have been if the old rules had remained in force.