“The U.S. financial system remains fragile and banks subjected to additional economic stress might need as much as $76 billion in capital, according to the results of International Monetary Fund stress tests.”

We at CERF have been long concerned about the strength of our financial sector.  In fact I suspect that the IMF study may be understating the severity of the situation.  That would be a problem.  Ask the Japanese what a weak banking sector can do to an economy.  The weakness of their financial sector, and their failure to correct those weaknesses, were a significant contributor to their 20 years of economic malaise.

Failure to promptly deal with our weak financial sector can have similar consequences for us.  You may think the new financial regulation fixes our banks.  It doesn’t.  It creates a new regulatory environment but it does nothing to address the problems that are keeping our banks from fully participating in our economy, inadequate capital and bad assets on their books.

The paper is clear, and that’s not what I’m confused about. I’m confused because Christina Romer is one of the administration’s top economists, and the insights in her research are not being reflected in policy.

Romer and Romer find that there is a large negative tax multiplier, perhaps over three percent. That is for one percentage-point change in taxes as a percentage of GDP, you get an opposite three percent change in output, GDP. So, a one percentage point increase in taxes, as a percentage of GDP, results in a GDP decrease of about three percent. Conversely, a one percentage point decrease in taxes generates about three percent GDP growth.

The size of the tax multiplier stands in stark contrast with the best estimates of the spending multiplier. For example, Valerie Ramey, in a very recent paper that is currently unpublished but will surely be published in a top journal, uses a methodology very similar to the Romers’ and finds the spending multiplier is positive and in the range of 0.6 to 1.2.

The implication of the research is clear. Tax policy is a far more powerful economic stimulus tool than is spending policy. Why isn’t this research reflected in current policy?

Beats me.

Given the popular belief that economic conditions are important to a party’s reelection, ignoring this research appears to be irrational.

The Romers’ paper has other insights. One is that the purpose of the tax change seems to matter. Tax increases intended to reduce deficits are less harmful than a random tax increase. The authors speculate that part of this phenomenon is that tax increases to reduce deficits are usually accompanied by complementary spending cuts.

The most fascinating result is that the multiplier works mostly through investment. A tax increase has a small negative effect on consumption, but a large negative effect on investment. Similarly, a tax cut’s stimulative effect is mostly through investment and not consumption.

These findings have important implications for today. A lack of investment is a key characteristic of this business cycle. If we are in a recovery, this is why it will be so weak. Obviously, raising taxes would be the opposite of a stimulus, and best avoided for now. Instead, we need the mother of all investment tax credits.

“After nearly two years of global economic and financial upheaval, shockwaves are still being felt, as we have seen with recent developments in Europe and the resulting financial market volatility,” Naoyuki Shinohara, the IMF’s deputy managing director, said in Singapore on Wednesday. “The global outlook remains unusually uncertain and downside risks have risen significantly.”

They are right in that uncertainty and risk are high.  I don’t think they’ve changed much, though, in recent weeks.   What has changed has been people’s perception of the risk.

For some reason, unfathomable to me, people started getting giddy about our economic prospects last August or so.  There were some good data points, but you had to look at them only in a cursory manner, and you had to ignore other discouraging data to believe we were headed for a robust recovery.

A more in-depth analysis and a broad look at the data gave no reason for a giddy attack.  The gains were mostly transitory, driven by temporary government programs.  Consumers, businesses, and governments were still over-leveraged.  The financial sector was still weak.

Still, it became consensus that our economic challenges were behind us.  The stock markets soared, and this was taken as another sign of economic prosperity just around the corner.

Now, the stock markets are down again, and some economists are talking about new risk.  I’d say the risks were there all along, and our forecast reflected those risks.

The idea has merit, and now might be a good time to implement it. Business investment has been extraordinarily weak for a long time now. Businesses may be feeling the lack of investment, but they are unwilling to invest now, because of uncertainty about the recovery. A tax credit might be just what is needed to push some of them into investing. It would also encourage hiring. Capital and labor are compliments. More capital would improve the productivity of labor, reducing the cost of hiring.

Certainly, it would be better to run a deficit to fund investment than continue the existing program of funding current consumption with deficits. This policy would imply a higher steady-state level of future capital stock than with the current policy, with greater future productive capacity. The higher future capital stock means the economy would have more resources available for consumption, further investment, or (heaven forbid) paying down debt.

Ricardian Equivalence asserts that only the amount of government spending matters, not how it is financed. This is the same thing as saying government debt does not matter. The logic is that taxpayers aren’t stupid. They see the debt as future taxes and save exactly what they need to pay the tax at some future date.

Now, Reinhart and Rogoff, in their highly recommended book “This Time is Different: Eight Centuries of Financial Folly,” provide evidence that high debt levels cause slower economic growth. They report a threshold: When debt exceeds 80 percent of GDP, gross product growth slows two percent. Today, David E Sanger, in a New York Times piece says “two numbers stand out as particularly stunning:”

“The first is the projected deficit in the coming year, nearly 11 percent of the country’s entire economic output. That is not unprecedented: During the Civil War, World War I and World War II, the United States ran soaring deficits, but usually with the expectation that they would come back down once peace was restored and war spending abated.

But the second number, buried deeper in the budget’s projections, is the one that really commands attention: By President Obama’s own optimistic projections, American deficits will not return to what are widely considered sustainable levels over the next 10 years. In fact, in 2019 and 2020 — years after Mr. Obama has left the political scene, even if he serves two terms — they start rising again sharply, to more than 5 percent of gross domestic product. His budget draws a picture of a nation that like many American homeowners simply cannot get above water.
For Mr. Obama and his successors, the effect of those projections is clear: Unless miraculous growth, or miraculous political compromises, creates some unforeseen change over the next decade, there is virtually no room for new domestic initiatives for Mr. Obama or his successors. Beyond that lies the possibility that the United States could begin to suffer the same disease that has afflicted Japan over the past decade. As debt grew more rapidly than income, that country’s influence around the world eroded.
Or, as Mr. Obama’s chief economic adviser, Lawrence H. Summers, used to ask before he entered government a year ago, “How long can the world’s biggest borrower remain the world’s biggest power?””

These are clearly challenges to the concept of Ricardian Equivalence. So, why would Ricardian Equivalence not hold? I think the answer is that Ricardian Equivalence holds for relatively normal debt levels, but it falls apart at high debt levels. Why?
One reason may be that at very high debt levels it becomes clear that future generations will be paying a significant portion of the debt. To the extent that taxpayers value their own consumption over their decedents’ consumption, the motivation to save is reduced. Economists have long accepted a bequeath motive for savings. So, this argument is not particularly persuasive to me.
A more believable reason is the one implied by Reinhart and Rogoff and by Summers: High debt levels increase the probability of default or inflation, a slow form of default. This would explain both low savings levels and challenges from other governments.

New unemployment claims also rose to 444,000, again exceeding “consensus expectations.”

There was also a report that will receive much less attention, but it is important. Inventories increased in November, the most recent month for which data are available. If inventories were increasing over the Christmas shopping season, and sales were declining, retailers ended the year with excessive inventory. That means reduced production in the first and second quarters of 2010.

2009’s third quarter output (GDP) growth was positive, and many expect a very impressive positive number for the fourth quarter, some as high as five percent. If the fourth quarter does come in with a strong GDP growth rate, it will be hailed as the harbinger of a soon-to-be-realized vigorous recovery.

Don’t buy that, and you won’t be disappointed.

That vigorous recovery may eventually come, but it is unlikely to come in 2010. Whatever growth generated in second-half of 2009 was government-supported consumption, ephemeral, not a solid foundation for economic growth, certainly not the basis for sustained vigorous job growth.

A vigorous recovery will be a result of investment, technological growth, and improved productivity. Recent productivity numbers have been encouraging, but in large part, they are probably the result of firms downsizing. Technological growth and solid job growth require investment, and that is the problem.

Our banks are in no condition to fund any vigorous expansion. Indeed, bank loans have been declining since October 2008. Businesses and consumers remain over-leveraged, unable to increase spending on consumption, unable to invest, desperately trying to reduce debt.

We won’t see a vigorous recovery until balance sheets are improved and banks can lend.

Government programs haven’t helped. Most of the spending programs have been consumption based instead of investment based. Some have been outright counterproductive, programs such as foreclosure-delay, paying interest on bank deposits at the Fed, and cash for clunkers. Even worse, the banking problem has been ignored, and now new taxes on banks are being discussed. That is as bad an idea as I’ve heard in a long time.

So, today’s data release showing a second consecutive weekly increase in new unemployment claims surprised many. The press called it unexpected. It was not unexpected or surprising here at CERF. In fact, it is entirely consistent with our forecast.

We think that GDP will decline modestly in the current quarter and in the first quarter of 2010. Then, we expect a very slow recovery, held back by over-leveraged consumers and businesses, but especially by a weak banking system. The recovery in jobs will likely be weak and trail the GDP recovery by a few quarters.

To answer the question, we think the recession is not yet over, and it probably ends in the second quarter of 2010.

CERF released its first United States and California forecast last week. The United States and California forecasts are pessimistic relative to consensus. Why?

In part, it is because so many forecasters seem to be using a model with a high autoregressive component. This is the equivalent of the weatherman forecasting that tomorrow’s weather will be similar to today’s weather. There thinking goes like this: Since the third quarter appears to be positive, the fourth quarter will also be positive.

Here in Southern California an autoregressive weather forecast works pretty well most of the time. However, you can improve the forecast by calling San Francisco. If it is sunny in Los Angeles but raining in San Francisco you might improve your forecast by including at least the possibility of rain.

We try to do the economic equivalent of calling San Francisco, and look at lots of data series. Some of those key indicators show significant weakness in the economy. Here are a few that we think are particularly important right now: bank charge-offs, the home ownership rate, foreclosures, capacity utilization, and an interest-rate-weighted TED spread.

It is difficult for us to see a near-term structural improvement in the economy when Bank Charge-offs are reaching new highs. It is unlikely that residential foreclosures will subside much given three factors: high unemployment rates, ongoing price declines, and a high home ownership rate. Of course, foreclosures add downward pressure on housing prices. Commercial foreclosures have yet to peak but are on the rise. Capacity utilization remains near historical lows. The TED spread has fallen, but the interest-rate-weighted TED spread is still very high.

The important thing about our forecast is not the point forecast of United States or California GDP growth for a particular quarter. Rather, we believe that there is still a critical mass of structural factors that imply future weakness in GDP growth.

That may be a bit premature. Dan discussed the GDP numbers yesterday, but there are more issues. Deutsche Bank thinks that half of U.S. mortgages will be upside down by 2011 and retail is suffering. Tomorrow’s jobs data could bring more bad news.
The fact is that after the housing crash and financial meltdown, financial institutions, businesses, and consumers were over-leveraged. After months of recession, consumers and businesses are in even worse shape. And now, the government is also over-leveraged. Where does the recovery come from?

Some are hanging their hats on inventory rebuilding, but that is a one-time shot, especially if the holiday season is as weak as we expect. Some are hanging their hats on the housing market, but at best that will only stop the bleeding.

The problem with claiming victory now is that the administration risks ridicule and losing citizens’ confidence. I don’t see how that helps the administration or the economy.

Maybe not.One of the key drivers of the 2^nd quarter’s improvement was an increase in Government spending of more than 800 basis points over the previous quarter.  That sort of growth in government spending is clearly unsustainable.

A way to focus more specifically on the health of the domestic economy is to look at domestic demand which is defined by consumption and investment.  (See chart below).  2^nd quarter domestic demand was -4.2 percent, a long way from zero, i.e. a long way from sustainable economic growth.

These data do not indicate that households, 86 percent of domestic demand, will increase their spending soon.  Newer data reinforce that conclusion.  Consumer bankruptcies surged in July to their highest level since October 2005.  Jobs are still contracting at four percent year-over-year.  Indicators of notices of default, foreclosures, and short-sales suggest that the residential real estate market is still suffering.

All this would indicate that banks still have plenty of challenges and aren’t ready to start lending again; businesses are not ready to invest, and most importantly, consumers are not ready to increase their spending.