Notes on the Economy – 05/22/09

William Dunkelberg

Professor of Economics at the School of Business and Management, Temple University (Formerly Dean of the Fox School of Business)

Learn more about Prof. Bill Dunkelberg.

1.  It is good news that the big banks are reporting profits, though, as some observers have noted, it’s not hard to make money with free funds (provided by thousands of smaller banks who cannot continuously roll over Federal Funds as a way to fund assets).

It is also good that they continue to write off huge chunks of toxic assets and bad loans.  The question there is whether or not the write-offs are of sufficient size, a question yet to be answered, either by events or government bureaucrats.  Little attention is paid to the fact that a large share of these big bank assets are funded by bank debt, not deposits (as is the case for small banks) and that these debts are guaranteed by the government.  It was the withdrawal of short-term funding that sealed the fate of Bear Stearns and Lehman and one can only speculate as to how long the mega-banks could stand without the guarantee (especially if they repay their TARP loans).

Meantime, the government is suggesting it might convert its preferred TARP stock into common stock.  This might be helpful based on the way capital adequacy is measured, but that would convey large voting rights to the government.  If government officials truly believe that the government can’t run these institutions well and that they don’t wish to, perhaps they would sign a pledge not to vote the shares.  Of course such a conversion would impose an “AIG Dilution” on the shareholders of the bank and perhaps make private investors less interested in providing capital with such a large government stake in the banks and a tendency of Congress to renege on its deals.  There are losses to take, and ultimately they are likely to fall on the least-well-represented constituency in Washington – consumers.  We just have to figure out the least expensive and most honest way to stick it to ’em and get on with it.

2

.  There’s been a lot of sweating happening in Detroit, and it wasn’t just at the NCAA playoffs.  GM and Chrysler must come up with plans that convince the government that they can survive without government support.  I’m not putting any money on that one.  Chrysler’s fate is sealed, if they don’t do a deal with FIAT, it’s over.  GM will probably not be allowed to fail, no matter how many of your tax dollars it takes to keep them in business.

Consumers have not been of much help to Detroit, or any of the car companies, cutting their purchases of new cars from the 16 million a year rate to 9 million cars while 14 million cars are typically scrapped.  This can’t last for long, many of the consumers who still have their jobs and wont lose them will get back to car buying this year.  But the lull in buying produced by the scare tactics of our government with a media assist was enough to lay bare the weaknesses of the industry.  In a good year, GM and Toyota produce the same number of cars worldwide, but GM has 5 times as many dealerships, an unsupportable cost structure.

Deals are attractive and most observers now expect the economy to bottom this quarter and begin to recover in the fourth.  Car sales will pick up but the industry will remain weak as long as government prevents the clean-up that recessions are supposed to undertake.  Protecting weak companies is not conducive to strong future economic growth.

3.  A pack of cigarettes cost $10 in New York so smokers there probably won’t notice that Congress just kicked the tax up by 61 cents a pack.  This is a regressive tax, hurting poor people whose incidence of smoking is much higher.  But for many consumers, withholding taxes were reduced, delivering a small tax rebate to low and middle income consumers.   The big changes are yet to come.The Federal government has to find a trillion dollars, give or take, to finance the spending Congress has authorized.  It must either raise taxes by that amount or borrow it or do a little of both.  Last year, the government paid over $400 billion in interest on the outstanding debt.  Some of this is paid to agencies like Social Security or the Highway Trust Fund, but for all practical purposes, these are agencies that provide revenue to the Treasury to finance spending.  The excess cash such agencies accumulate is given to the Treasury in exchange for low interest Treasury bonds.  So we’ll pay about $1,300 per man, woman and child this year to cover the interest on the debt we currently have but can look forward to far higher interest payments in the future as Congress adds trillions to our Federal debt.

4.  Interest rates are unlikely to stay this low for very long, so we will have more interest to pay on what we owe today as well as on the new debt Congress will authorize to finance its spending plans.  In the meantime, the low interest rates are a real blessing for prospective home buyers!

March was the best stock market since the 1930s.  Of course, with stock prices at such low levels, it’s no surprise that percentage gains are large and impressive.  Some bank stocks are up 50 percent since the beginning of the year, but look where they started!  Going from $1 to $2 is a 100% increase.  But it’s a real gain and the kind of enticement that will result in more investors testing the water, which will propel markets up further.

Fear of missing the train as it leaves the station can drive the stock market up quickly.  After all, there are trillions of dollars on the sidelines in money market funds earning virtually nothing.  This money is becoming more anxious and will start to find its way back into stocks.

But earnings season is just starting, and the numbers are gong to be horrible.  The market expects bad news, but it could be worse than expected as firms often take advantage of the need to announce bad news to clean out the refrigerator and dump all the bad stuff they can lay their hands on.  But, once earnings are out and the economy continues to show signs of improvement, the markets will be poised to take off, not to record highs, but enough to provide early investors with a nice return.

5. Tax Freedom day was April 13, that’s the day that you could start keeping the money you made for yourself, well kind of, as there are a plethora of other little taxes that probably are missed in the counting.  And, taxes are about to go up, most certainly if you are “rich”, and just what that means is not clear yet.  We are half way through the Federal government’s fiscal year and it appears that we are about to run out of tax revenue, so we’ll borrow our way from here till September 30, the end of the fiscal year.  And the borrowing won’t end there, since extraordinarily high spending will keep the deficits at trillion dollar levels for some time to come.  More taxes will be needed just to pay interest on the growing debt, $800 per man, woman and child this time around.  The higher taxes will produce a “headwind” to economic recovery and growth.  Contrary to the opinion of some, it was the Y2K Dot Com boom that produced budget surpluses in the late 1990s, not Mr. Clinton’s tax hike on the rich.  If Congress had anticipated the surge in revenues, they surely would have budgeted to spend them.  Lucky we economists aren’t the best forecasters.6.  Mixed news on the housing front, foreclosures rose because the moratorium expired.  But, purchases by first time buyers rose and although March housing starts were lower than February, we are up from the beginning of the year.  And the best news, mortgages have never been cheaper.  Time to go get one.

New home sales during March slipped just 0.4% from February, to 356,000 units.  Declines are never good news but in this case, we can probably put a positive spin on the number, it was small and February sales were revised up by whopping 8.2%.  Bottom line, February sales took a nice jump and March was basically unchanged.   Sales of new single-family homes are now showing signs of forming a bottom after having declined by more than 75 percent since 2005.

The median price for new homes did fall a bit, but this is the result of builder’s attempts to clean up the excess supply of new homes in heavily overbuilt markets such as Ft.Myers and Cape Coral, Florida, where the foreclosure rate is the third highest in the country.  Las Vegas still tops the list, but Ft.Myers appears to have the greatest oversupply of single family homes rather than condos.

The supply of unsold homes continues to decline as new single family housing starts continues to run at a rate of only a third of the average annual number needed to satisfy the demand of new households.  The inventory of unsold homes is only half of its peak level reached in 2006.
Elsewhere in the economy, the trade deficit improved in February, this will soften the decline in GDP for the first quarter, but won’t keep it from being a bad number.  Unemployment claims have been pretty steady, though high. Inflation of course is nowhere to be seen and mortgage interest rates are about as low as they will ever get.  But to get a loan, you have to be a traditional A credit with 20% down.  Underwriting standards have returned to sensible levels.  Unfortunately many consumers that would have made solid homeowners were enticed to over-buy and over-borrow and it will be some time before they can be rehabilitated.  The economy is starting to right itself, so the worst is probably over.  Markets where overbuilding was serious will lag the rest of the economy as construction activity is an important part of all regional economies.  Here in our area, oversupply is less of a problem.

7. About 500 giganto (a very large number) tons of CO2 are dumped into the atmosphere every year (CO2 makes up less than 1% of the atmosphere), about 7 giganto tons come from human activities.  Of course, live stock does more damage to the atmosphere than all of the cars, trains, and planes that mankind uses each year.  This suggests that if all man-made CO2 were eliminated (we stop driving and stop breathing), not much would happen as the planet would still dump about 500 giganto tons into the atmosphere.  The issue of course is not whether or not the globe is warming, we have thermometers.  It is, rather, whether man made CO2 makes a difference.  After all, Mars has been warming too and there are no cars or utilities there (maybe it’s the Sun?).

Whether or not the Administration truly believes in man-made global warming, it is clear that they are on board for “cap and trade”, a scheme that promises to generate the massive amounts of tax revenue needed to fund its ambitious social reforms.  And, rather than blaming Congress, ordinary consumers will picket the utilities instead of having bus tours pointing out the homes of members of Congress who imposed this massive tax.

Since peaking in 1998, the earth’s temperature has declined every year for the past ten years.  The administration’s EPA and energy czars will probably argue that this is caused by disruptions in weather patterns and air and water currents caused by past global warming.  He will certainly be a proponent of “cap and trade” and has already warned of the hurricane risks that will be faced this year due to our alleged atmospheric mischief.  To date, these warnings have not been proved out, but like a good economic forecaster, if we predict a recession every year, one will eventually come (oops, it came and we didn’t predict it!).

8. Well, the first quarter economy was about as bad as we predicted, a repeat of the fourth quarter decline of 6.3%, this time down 6.1%.  Or was it?  Here’s the difference.  GDP, Gross Domestic Product, measures production activity in the current period.  That’s important because making stuff produces jobs.  But if you buy a car that was made last year, that just reduces inventory, but doesn’t provide any new employment.  So, we see your spending go up, but subtract it when your purchase involves buying something out of inventory rather than something made this quarter.  OK, so here’s the good news hidden in the bad news about first quarter GDP growth – consumers actually went out and spent, but a lot of what they bought was made last year, so the spending didn’t create jobs.  Half the 6% decline was due to inventory reduction.

That’s good news because (1) consumers are spending more and (2) there are only so many cars on the lot, only so much stuff on the shelf and shelves are getting pretty empty.  Since consumers are spending again, businesses will order some new stuff to replace what consumers are buying.  This in turn will raise employment at the manufacturer.  And so it goes.  Bottom line, the growth number for the first quarter was not nearly as bad as it sounds.  If consumers keep spending, the recession is over.  We are running out of inventory and soon business will have to hire more people to make more stuff.

This process is taking longer for housing because the inventory build up was so large and we sold a house to just about everybody that could possibly buy one.   Indeed, many who bought should not have, taking on obligations they could not handle or continually refinancing to take advantage of rampant appreciation that soon collapsed, leaving them upside down in their homes.  But, this too will end and new construction will resume.  It will just take a bit longer to use up our inventory of houses than other consumer goods.  But we’re on our way.

9. The economy continues to show improvement as the job numbers for April were announced.  Just as there was good news hidden in the negative 6% growth reported in the first quarter because consumer spending growth was quite solid, so the higher unemployment rate was more a result of more people deciding to look for a job and less due to workers being laid off.

The unemployment rate is based on a survey of 70,000 households across the U.S.  If a person does not have a job and is actively looking for a job, he is counted as unemployed.  If more people start looking who were not working in the past, this will push the unemployment rate up just as losing a job and searching for a new one will land you among the measured unemployed.  So in April, fewer were laid off than in March, but more people started looking as new entrants to the workforce.

So, 160,000 fewer jobs were lost than in March, but with more people looking for a job, the unemployment rate rose to 8.9%.  It will probably go a bit higher.  Based on the April survey from the National Federation of Independent Business, owner optimism bottomed in March and posted a 6 point bounce in April, led by improvements in plans to create more jobs, invest in inventories and make capital expenditures. Small businesses produce half of our private sector output and employ most of the private sector workforce, so this turnaround in optimism is welcome indeed.  We can’t have a recovery without these important firms on board.

So, the economy is starting to improve, led by consumer spending and now small businesses.  There has been little help from the mis-labeled  “stimulus package”, it’s impact wont be felt until next year after the private sector has already rescued itself.  The housing sector will still be a drag for this year, but it too should start showing more life as the year progresses.