Economic Trouble Spots (Updated) Posted by: Dale Franks
on Wednesday, December 20, 2006
Robert Samuelson notes that, while employment is still strong, and many parts of the economy are humming along nicely, there are some warning signs cropping up. His article mirrors some of the concerns I've expressed recently, such as frothiness in IPOs and monetary policy oddities. Mr. Samuelson concentrates on three perceived weaknesses.
First, the real-estate bust. Speculation helped fuel the boom — and now it's payback time. In the past year, housing starts have dropped 27 percent and sales of new homes 25 percent. With buyers waiting to see how low prices go, inventories of unsold new homes have risen 14 percent. Some economists see recession. Falling home prices could weaken consumer confidence and spending. By year-end 2007, unemployment will hit 6.3 percent, predicts Dean Baker of the Center for Economic and Policy Research.
It is an interesting phenomena of price changes that, when prices start to move, the response of buyers tends to exacerbate price movements. Let me explain this. When you take Econ 10X, responses in supply, demand, and price seem to move along the curve very smoothly, which each of those three factors moving in tandem.
In the real world, especially for big-ticket items, this is not the case. Let's take the current situation in housing. The standard economic theory is that as prices drop, more and more buyers step in, so that price and demand equalize themselves smoothly. What actually happens is that when prices begin to drop, demand plunges initially, because buyers want a better deal. They want to see how low prices will fall before making a purchase.
After all, the difference between paying $24.95 for a widget and $19.95 just isn't large enough to to make a lot of people hold off on purchasing widgets because they may get a better deal in 30 days. The utility of delaying a purchase for 30 days in order to save 5 bucks is pretty marginal. In housing, however, the difference between $249,900 and $199,900 is some serious scratch. Saving $50k is enough to wait 30 days for.
Eventually, of course, prices drop low enough so that the customers are drawn back into market, but until then, the slide in home prices can be both steep, and precipitous.
In addition, for many sellers, things are tighter than they appear. A lot of people have cashed out equity in their homes. If prices continue to fall, that "equity" is not only gone, but the homeowner ends up owing more on the home than he can possibly sell it for. That disappearing wealth and increased indebtedness implies that those homeowners will have to slow down consumer spending, in order to clean up their balance sheets.
So, dropping home prices can have two pernicious effects. As unsold inventories rise, construction falls, increasing unemployment across the construction sector. meanwhile, current homeowners begin feeling a debt pinch that can only be addressed through reducing spending.
Second, turmoil in the auto industry. Unpopular models, steep gas prices and high labor costs have forced huge cutbacks at Ford, General Motors and Chrysler. Pressures could intensify. Vehicle sales will decrease to 16.1 million units in 2007 —the lowest since 1998 — forecasts Moody's Economy.com. That would be down from 16.5 million in 2006 and almost 17 million in 2005. Since June, manufacturing jobs have dropped by 95,000; about 90 percent of the loss relates to autos and home building (lumber, furniture).
Manufacturing is down across the board, and has been dropping for the last 6 months. The most recent ISM Index indicates that manufacturing is actually already in a shallow recession, even though the services sector is still going relatively strong. Manufacturing orders in general, and durable goods orders in particular, have been declining, especially in recent months. That's not a healthy sign.
Finally, and most important, skewed trade. America has gorged on imports while other countries have become overly dependent on exports. In 2006, the United States will run a current account deficit of $878 billion, estimates the Organization for Economic Cooperation and Development (OECD). Meanwhile, China, Japan and Germany will record surpluses of $211 billion, $165 billion and $117 billion. (The "current account'' is an expanded trade balance.) These huge imbalances could destabilize the world economy through a currency crisis or trade slump.
This is where things get dicey. In the best of all possible worlds, the way to fix this would be for US exports to jump higher. And, over the long term, that will probably happen as developing countries get increasingly richer, and can afford the high-tech items that form the base of US exports.
In the short term though, there is always the worry that the current account deficit will bite us. If investors lose their taste for dollar-denominated securities and begin repatriating them them, the the value of US investments will decline. Moreover, countries that export goods to the US will see price increases that will make those exports less competitive, and will slow their economic growth.
And make no mistake: eventually that repatriation will happen. After all, you have to repatriate your foreign investments eventually. You aren't investing money just to kiss it goodbye, are you? Sooner or later, you'll want to spend those profits. The real question is whether that repatriation—in the aggregate sense—will consist of pulling cash out of the US, or buying US goods and services for import. Fortunately, there is perhaps a bit of a bright spot on that score.
A brighter spot is Europe, where domestic growth is accelerating. From 2001 to 2005, annual growth in the euro zone (the 12 countries using the euro) averaged only 1.4 percent. Now the OECD forecasts 2.2 percent in 2007 after 2.6 percent in 2006 — and that might go higher.
As Mr. Samuelson writes, if that translates into importing more US goods and services, then that would be a good thing. Whether it will come fast enough to help head off or moderate a US recession in the nest year or so...well, that's a bit more murky.
well I keep hearing about the crash in home prices, but it never comes. I wish it would, I have been wanting to buy some property but I am one of those who you speak of. I will wait until the bottom falls out and buy low.
For 25 years and counting people have been predicting that the "trade deficit" would eventually lead to economic ruin for the United States. Kind of like when Paul Samuelson predicted for 30 years that the Soviet Union would pass the United States economically in the next 10 years. When a theory fails to make any correct predictions enough times you would think people would come to the conclusion that the theory is wrong. You’d think.
The trade deficit does not measure profit or return on investment, therefore it has no ability to indicate the "health" of the economy.
DALE RESPONDS: Huh. Since I didn’t predict economic ruin, or use the trade deficit to measure the health of the economy...what’s your point?
Though there’s short term pain, a slide in house prices is good in the long run. The people who make most of the money during bubbles are speculators, and they also take a lot of the hit at the end of the bubble. But Joe Ordinary is his late twenties or early thirties is priced out of the housing market when prices reach the stratosphere, and he gets his chance to enter the market when prices recede.
I feel sorry for those folks that bought into complex ARMs with interest-only payments for several years. They’re going to get hammered as their equity goes negative. But they made the choice to live a level beyond what they could realistically afford, so they’ve got a painful lesson to learn about that. Apparently every generation has to learn that housing prices don’t go up forever.
That is my outlook in a nutshell. Though I would add in a few more issues. We also have other assets which are extremely overvalued, and pretty much world wide. Specifically much of the worlds bonds and stocks, especially stocks in the US are trading at historic valuation levels. For most segments of the stock market we see levels that are higher than even 2000. Large cap growth and technology being the exception, though even these are at levels well above the norm and any reasonable economic rationale for owning them.
Thus, if the economy slows and the historically high profit margins contract we could see a very ugly stock market. That of course exacerbates the wealth effect of a declining housing market. It would also mean credit spreads will likely widen, crushing lower quality bonds and emerging market debt. That could be ugly, though unlike in 1998 the emerging markets as a whole have lots of reserves (that buildup is a large part of the reason for the current account deficit) and while ugly it shouldn’t result in the economic upheaval we saw then.
No likely disaster, but the economy is poised to underperform.
Yes, the problem of the trade deficit is exaggerated, but that doesn’t mean it isn’t an issue. While trade deficits are pretty much baked into the cake with the US due to us being the reserve currency of choice, it does mean that once countries have reached what they feel are adequate reserves for their countries the increasing repatriation of assets to the US could be a difficult adjustment. The home countries economies will have to adjust to a less export led model and the US the opposite. That means capital has to be liquidated and redeployed. That can, if the adjustment isn’t sudden, be done as part of the normal churn of an economy. If it moves too rapidly it can lead to downturn’s. That is capitalism.
One issue is the worry that some countries, including China, are artificially accumulating reserves above what they need for domestic political reasons. Accumulating reserves lowers living standards over what they otherwise would be. However, with China so dependent for jobs on exports the adjustment to a situation which emphasizes allowing the Chinese to spend more of their earnings both domestically and internationally could lead to a slowdown as capital is redeployed in the short run. That could feed unrest. This could mean that when China and others eventually slow the accumulation, after having kicked the issue down the road, that the effects of the change in policy could be more severe.
Similar to the possible problem with the trade deficit is the issue you bring up in respect to housing. Stopping housing from adjusting makes the issue worse down the road, so yes, a slowdown is probably necessary and I am glad the Federal Reserve isn’t trying to ride to the rescue too quickly and just inflate other bubbles throughout the economy as cheap credit is used to float asset prices beyond any fundamental rationale for owning them. Let me give an example of people not seeing the value as opposed to speculating on price.
I had a client who bought a house on the beach in Florida. It was in Seaside for $750,000. Eight years later it was appraised for over 4 million. This is a house they stayed at a few weeks a year. They didn’t want to sell it because they loved it (a reasonable reason) and number two they had made so much money and didn’t want to sell something which seemed to be such a good investment (bad reason.) I asked a simple question: "If you had 4.5 million right now, but not the house, would you buy it or would you use the money for something else, such as retirement?" Answer "No, I would never pay that much for that house." My answer, "so why do you think the market will bear that price for long? Would you even pay 2 million for it?" I explained that in fact economically it was exactly the same to lock up 4.5 million in that house as buying it with 4.5 million in cash. He was in fact spending that much money on something that he admitted wasn’t worth close to that to him. He, and any likely buyer, was speculating, not investing or buying something they really valued that highly. He sold it this summer for over 5 million and he can now retire. Maybe the house will go up a lot more down the road, but his financial future is secure because he finally looked at the value of the asset instead of the speculative furor. That kind of thinking gets worse the longer things go on. So yes, valuable lessons and fewer problems the earlier such nonsense stops.
I hope the person he sold it too really wants the house and that it was bought because they loved it and not because it will automatically be worth more down the road. That seems unlikely, though not impossible.
Uhhh, manufacturing is not down hard and US export set records just about every month, as they did last month. The trade deficit is there because foreign investors regard the US as the safest place to invest, and foreign governments aren’t willing to let their currencies rise. Both are fundamentally a sign of respect for US economic policy and productivity.
As long as we run our economy more wisely than others (a good bet at least until 2009) the trade deficit will not be a problem.
Uhhh, manufacturing is not down hard...
Huh. And yet the ISM Index dropped below 50 for the manufacturing sector last month (indicating a contraction), down from 57.3 in April. And the last manufactured goods orders figures show 4 straight months of declines in orders, with the most recent drop being 4.7%, with durable goods orders down by 8.2%.
How terribly odd. Apparently the economic statistics for manufacturing are completely wrong.
Really, thanks for setting me right about that, Larry. It’s good to hear from someone who knows the true state of manufacturing utilization, unlike those morons at the Institute for Supply Management. You’ve certainly set me right about one or two things, let me tell you.
No doubt, economic growth is slowing, yet the idea that we are heading into a recession does not follow from some of the facts presented. You wrote (in the last comment above):
"...Huh. And yet the ISM Index dropped below 50 for the manufacturing sector last month (indicating a contraction),..."
You are correct about the manufacturing index trending down a bit mainly due to the auto industry, but the ISM web site itself contradicts the thesis that such data indicates that we are heading into a recession. The current reading would indicate GDP growth of 2.4% annualized.
from the ISM website (emphasis added):
A PMI in excess of 42 percent, over a period of time, generally indicates an expansion of the overall economy. Therefore, the November PMI indicates that the overall economy is continuing to grow while the manufacturing sector has now entered a period of contraction. "The past relationship between the PMI and the overall economy indicates that the average PMI for January through November (54.1 percent) corresponds to a 4.1 percent increase in real gross domestic product (GDP). In addition, if the PMI for November (49.5 percent) is annualized, it corresponds to a 2.4 percent increase in real GDP annually."
The Current Account Deficit (often mistakenly called the trade deficit)has been growing for many years. There are two key factors that cause our CAD to grow irrespective of trade issues. They are: 1) the Federal budget deficit which offsets personal and business savings in the National Savings Account; 2) Our propensity to invest rather than ’save’. Yes, that’s correct. If you make an investment rather than putting the money in a bank account, that increases the CAD.
You quote Samuelson:
’...Meanwhile, China, Japan and Germany will record surpluses of $211 billion, $165 billion and $117 billion...’
I guess he’s saying that’s good. Yet, China is a developing economy highly dependent on exports to us. Japan has just recently begun recovering from a multi-year economic slump. Germany has had very low economic growth and unemployment north of 10%.
Factors such as trade surpluses or deficits are not determinative in and of themselves. The U.S. is an attractive arena for investment and Americans and foreigners alike find it so. That seems good to me even though we have a growing CAD.