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Ahead of the Curve Issue No. 4

A New Blueprint for Recovery

AOTC: What Ails the Economy Today and What to Do About Fixing Tomorrow

Anthony Randazzo
July 8, 2011

There is a moment towards the end of every drunken party when bingers sense the ridiculousness of their epic self-delusion that taking 14 tequila shots won't come back to haunt them in the morning.  Similarly, mainstream economists are waking up to their own haunting reality that the rosy economic growth scenarios they had projected for 2011 were beyond delusional. According to today's job report, unemployment rose to 9.2 percent for the month of June, the highest level this year. Housing also continues to falter, and to make matters worse, the Federal Reserve has downgraded its outlook on GDP growth for the next year.

So a simple question: what is going on with our struggling economy?

The answer can go on for pages and is hotly debated. However, I think we can get a sense of the problems facing the economy by taking a snapshot look at unemployment, housing, GDP, Wall Street, and the Federal Reserve.

Structural Unemployment

Right now it seems like the only place to find work is Texas. The overall unemployment rate ticked up to 9.2 percent in June, the highest point it has been all year. The median time individuals remain unemployed rose to 22.5 weeks while a total of 14 million Americans remain on the job hunt. Perhaps more damningly, initial unemployment claims were more than 400,000 last week for the thirteenth straight week in a row, a bad sign for the future. 

The chart below explains one reason for the increasingly bad unemployment numbers. The private sector did add 57,000 jobs last month, however, this is only a 0.05 percent improvement from May, and the rate of growth has been on the decline for several months. Meanwhile, government employment has been trending downward, with 39,000 federal, state, and local workers getting laid off last month.

Unemployment Situation

Despite the dismal employment picture, the Bureau of Labor Statistics reported in May that there were 3 million job openings the last time they checked. If you were to look at just the Fortune 500 companies alone—such as J.P. Morgan Chase, Best Buy, General Electric, or Microsoft—you'd find some 100,000 job listings.

The root of this misalignment in employment is structural. Fewer people are retiring because their savings were hit by slumping markets and depleted 401(k)s, leaving less openings for recent graduates to start working their way up the corporate ladder. In fact, those students who just completed degrees are facing a 17 percent unemployment rate for their age group.

Teens have it especially bad, 16 to 19 year olds have a 50 percent higher unemployment rate this summer compared to a decade ago—largely because of the minimum wage increase in 2009.

Further complicating issues in the job market are an unskilled labor force and housing woes. If Dell and IBM both want to hire a slew of software engineers, ideally they'd compete for the best workers and drive up wages. However, the math and technical skills required for these jobs are lacking among today's unemployed. This is because a bulk of the unemployed have come from the manufacturing sector, making it difficult to fill employment needs. In a similar scenario, a company like Microsoft may want to hire 6,000 workers at its Redmond, Washington headquarters, but those whom are qualified to fill the positions are stuck in places like Nevada and Florida because they can't sell their homes. These jobs thus remain open while the unemployed stay stranded in a jobless purgatory.

President Obama joked recently that his shovel ready job generating programs weren't exactly shovel ready. Not a very funny joke for those 14 million-plus struggling Americans. Only the British appear to be laughing, as their unemployment is falling at a faster pace than any time in the past 10 years.

Housing Not On Solid Ground

New home sales fell 2.1 percent in May and existing home sales also continued to fall, sliding 3.8 percent. These housing sales numbers are some of the lowest reported figures since we began keeping records. The reason for continued troubles in the housing market can be boiled down to four basic elements.

First, housing prices are well-off their historical trend and need to fall further before we can begin to see any recovery. The administration's policies and programs over the past few years have significantly propped up prices and contributed greatly to the bubble in 2006.  Prices need to fall anywhere between 5 percent and 25 percent before a real recovery can begin, confirming the myth that housing makes for a good long-term investment. Price declines will mean more households facing negative equity.

Second, housing inventories need to be minimized. There is a massive supply glut of homes today (about 4 million) that needs to be sold before the residential construction industry can fully return. What is worse is that there are about two million homes in the shadow inventory-homes in the foreclosure process for one reason or another and not officially on the market to be sold. Whether because of a massive default volume or because of federal programs, it takes more than 18 months between the day a homeowner misses his first payment to the day the lender forecloses. In Florida, it takes 807 days, on average, and some homeowners have gone as long as five years without making a payment. There is a lot of deadbeat debt to get worked out.

Third, state attorneys general and federal banking regulators have been waging a war on mortgage servicers. Instead of simply levying a fine on these companies for mistakenly foreclosing with legal standing on some families, the state AGs have sought to force a new, universal set of servicing standards on the mortgage companies and are trying to extract a pound of flesh from the companies to create mortgage assistance programs. Putting the effectiveness or ineffectiveness of these programs aside, the process has gotten muddled and overextended. The longer this process takes, the more uncertainty there will be for mortgage investors considering jumping back into the market. Adding insult to injury in the housing market, the process has delayed foreclosures and added to the shadow inventory.

Finally, the fourth matter to address is the inexplicable continued existence of Fannie Mae and Freddie Mac. These gigantic subprime elephants still dominate the market, and Congress has barely moved any legislative reform past the subcommittee level in the House. Plenty of ideas are on the table for how to deal with them, but little action has been taken.

Double-Dip GDP Concerns

The economy expanded at a rate of 3.1 percent for the year 2010, inspiring many to write rosy outlooks for this year and the next. However, first quarter 2011 GDP numbers came in well below expectations at a dismal 1.9 percent. In the wake of the economy's poor performance, most economists have since dropped their outlook for economic growth, including Federal Reserve Chairman Ben Bernanke, who lowered his GDP projections for 2011 to 2.7 percent, down from the 3.3 percent number he proclaimed earlier this year. To say this is worrisome is about as understated as calling Pete Townshend a mere guitarist.

Of course, GDP at its core is a relatively defective way of measuring economic growth. As Ludwig von Mises put it, "The attempts to determine in money the wealth of a nation or of the whole of mankind are as childish as the mystic efforts to solve the riddles of the universe by worrying about the dimensions of the pyramid of Cheops." But still, breaking down GDP into its components does tell us something about the health of the economy.

A majority of economic growth in the first three months of this year came from businesses buying up inventory, rather than businesses selling to consumers. The growth in final sales, as opposed to purchases between wholesalers and retailers, grew only 0.15 percent since the end of 2010. Martin Feldstein wrote in The Wall Street Journal last month that we are seeing "a collapse in payroll-employment gains; a higher unemployment rate; manufacturers' reports of slower orders and production; weak chain-store sales; and a sharp drop in consumer confidence." Plus, real exports slid from an 8.6 percent growth rate at the end of 2010, to a 7.6 percent expansion in the first quarter this year.

The economy is not going to grow on an inventory build-up alone and we won't see a recovery without strong export growth. Bernanke has tried to argue that the negative trends are temporary, despite his outlook downgrade. His supporters point to the recent decline in oil prices and to the fact that supply chain routes are getting back up and running from the Japan earthquake. But the economy in the second half of 2011 will be facing a wind-down of the stimulus spending program, continued cuts in local government spending, more housing troubles, and an unpredictable European and Chinese demand for U.S. exports. 

An economy with offsetting economic conditions that either leads to a slight rise in GDP or a slight decline may arguably be worse than a double-dip. Clearly robust economic growth is the ultimate goal, however, if the economy continues to draw-out on this stagnating path, a deeper, more prolonged recession may ensue. We need something more.

Wall Street Investor Schizophrenia

Beyond the bad economic news, there are regulatory constraints handcuffing economic activity. A number of foreign banks have sold their U.S. operations as new capital rules and business activity limits begin to take effect. Fee rates at commercial banks have jumped in order to compensate for lost revenue as a result of the new rules that limit the amount banks can charge on debit card transactions. People from small community bankers to the NAACP are even claiming that new definitions for qualified residential mortgages are racist and threaten to destroy the housing financial sector.

Compounding the negative effects of this oppressive regulatory environment, many corporations in the United States and Europe have been shedding debt as a result of a slow down in loan applications which has caused a sharp drop in traditional business for Wall Street's top financial institutions. That has made life profoundly uncomfortable

In response, the Office of the Comptroller of the Currency said last week that more than one third of banks are easing their standards for the last fiscal year. Specifically, consumer lending has seen standards relax for the first time in three years in response to improved credit market conditions and competition. However, as an indication of the still turbulent times, the OCC found that at least 30 percent of banks actually tightened standards further on credit cards, home equity loans, mortgages, and commercial construction lending.

One reason for this is that the continuous downturn in housing also means more losses for the banks-as much as $80 billion more than currently expected according to analysis from S&P. This means that the historically high amounts of reserves banks are holding onto won't be coming down anytime soon.

The Fed Caught In Its Own Trap

What won't be going up anytime soon are interest rates. The Federal Reserve continues to see its role as stimulator of the economy, despite Bernanke suggesting that a third round of quantitative easing would be unproductive. Under the zero-interest-rate-policy, the Federal Reserve has backed itself into a corner in at least two ways.

First, because the Fed has expanded its balance sheet largely with toxic mortgage debt purchases, it is susceptible to downward swings in the housing market. An increase in interest rates will mean more expensive mortgages, and in turn less demand for housing. The law of supply and demand suggests this will create downward pressure on housing prices and lower the value of the Fed's mortgage related assets.

Second, if the Fed increased interest rates it would raise the U.S. government's cost of borrowing. The average Treasury Department borrowing rate over the past 20 years is 5.7 percent, but the current rate is around 3 percent. If interest rates rose, normalizing the Treasury's borrowing costs, it could add trillions to national spending expenditures. This would put political pressure on Congress to cut more spending and attack the national debt more ferociously-a good thing-but it would also make more spending in the future unlikely, and Bernanke is on record as believing Capitol Hill should be doing more to stimulate the economy.

What We Can Do About It

Run for the hills and convert to Zoroastrianism... Okay, I joke, but it might be easier than what we really must do to get out of this mess.

More stimulus and quantitative easing are not the answer. We cannot spend our way out of this recession, nor are there potential cuts in the federal budget that will alone unleash the private sector to spark a real recovery.

To address unemployment and GDP growth we should roll back America's regulatory environment and loosen trade restrictions. The Index of Economic Freedom for 2011 was released this week and for the third year in a row, the U.S. has dropped. Now in 9th place behind Hong Kong, Singapore, and Denmark (and barely above Bahrain), America continued its decline due to reduced "Business Freedom" and "Trade Freedom."

The nanny state culture where consumers and businesses are not being protected but rather parented could be dramatically cut back through the elimination of occupational licensing in many states and reducing red tape for construction and development permitting.

The more attractive it is for companies to produce here in America, and the less oppressive the permitting process, the more likely we'll see manufacturing return to our shores and the more job openings will be created and filled. Repealing Dodd-Frank and putting in place a regulatory system that does not improperly restrict business activity, but instead effectively incentivizes Wall Street to manage risk, would be beneficial as well.

We also should be pursuing more free trade agreements. The pending pact with South Korea is expected to generate 50,000 to 100,000 new jobs as American companies gain better access to Korean markets. The recently negotiated free trade deal with Columbia would boost exports to the South American nation by 7 percent from Florida alone, and an FTA with Panama opens up a platform for U.S. businesses to increase their investment opportunities all across the Americas. Not only should these deals be pushed through, but America should also negotiate free trade agreements with Turkey, New Zealand, the European Union, and many others.

In addition to trade policy reforms, we could also open up our borders to more tourism through changes in visa policy. American companies can also become more productive by removing quotas on H-1B visas.

The housing recovery process can be moved forward simply by Washington ending its programs that aim to prop up prices. At present, they are only supporting artificially high prices and growing an already bloated shadow inventory. State and federal regulators need to finish their mortgage servicing settlement talks and Congress needs start the process of unwinding Fannie Mae and Freddie Mac.

Changes are needed in monetary policy as well. Not only would a natural, market induced increase in interest rates help get the housing sector to its bottom faster, allowing real recovery to start, but a consistent strong dollar policy could make America a more attractive place for foreign investment. 

This is a laundry list of changes that are not likely to be easily embraced overnight. But the depth and complexity of what needs to be done, combined with the extensive range of problems in the economy, illustrate why it has been so challenging for the Obama administration (and I did not even mention the need for a tax code overhaul). Still, these ideas represent the pillars of a blueprint that would greatly benefit the American economy. Recovery would not be immediate, but it would be stable and sustainable. That is a goal and result we should all be able to live with.


Anthony Randazzo is Director of Economic Research


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