The estimate is higher than my forecast by a fair amount actually, but in the grand scheme of forecasting, forecast errors, and the direction of change, I am reasonably happy. I had forecasted the increase in growth with trepidation because the economic fundamentals remain weak.

The fourth quarter data implies that the economy grew 1.7 percent in 2011, compared with 3.0 percent in 2010.

What were the drivers of the increase in fourth quarter growth? Consumption and Investment expenditures both rose, $50b and $80b respectively, trade was little changed, and government expenditures fell about $30b.

Investment expenditures are driven by a four main components, business structures, equipment and software, residential, and inventory investment. All of these components are volatile, but one of them, inventory expenditures, is super volatile. Sure enough, about $55b of the $80b investment expenditure increase was due to inventory investment. I hope that the shelf-stocking was not overdone for if it was, there would be a slowdown in inventory investment this quarter.

Another interesting movement within Investment was residential, up at an annualized growth rate of about 11 percent. While residential investment in states like Nevada, California, Florida remain at historic lows, it is booming in states like North Dakota, Oklahoma, and Texas. We can thank the middle part of the country for this source of growth.

The $30b pullback in government expenditure breaks down to a $20b decline in Federal and a $10b decline in State/local expenditures. The Federal change was due to a defense spending contraction, as non-defense expenditures rose slightly.

Inflation, as measured by the GDP deflator, fell dramatically from 2.6 percent in third quarter to 0.4 percent in fourth quarter. Subdued inflation in a time of relatively high unemployment is a good thing, as it helps those unemployment or partially-unemployed households manage expenses.

The BEA measure of the personal savings rate fell from 3.9 percent in third quarter to 3.7 percent in fourth quarter. This worries me, as household debt levels are still high. I have argued this before and will do it again: consumption in an era of high household debt does not help the economy. What is needed is savings and investment. Future growth depends on it.

The jump in consumption growth from second quarter’s rate, which was 0.7 percent, implied that the savings rate fell. The BEA measure of the savings rate fell a full percent, from 5.1 percent to 4.1 percent. The economic growth estimate of 2.5 percent, with the approximate job growth estimate of about one percent, implies that output per worker growth was positive again in third quarter. It was negative in the second quarter.

What does all this mean?

Turning to the output per worker first, this measure of gross labor productivity, which contracted in quarters 1 and 2, increased in third quarter. Increasing labor productivity is a key driver of per-capita income growth, and it is a feature of increased innovation in production. It appears likely now that the negative labor productivity of quarters 1 and 2 were just temporary, and that productivity is returning to trend. If true, economic growth will benefit.

I am pleased to see the investment in structures and equipment/software. Investment raises the productive capacity of the future economy, thereby providing greater choice for either investing or consuming in the future.

The rise in consumption and fall in savings worries me. While it benefits current growth, it is likely to prolong the balance sheet rebuilding that I feel is necessary to ensure healthy growth in the future.

The question of which way the savings rate will go is also one of the big macroeconomic forecasting challenges of the day. Some Economists argue that because of the Great Recession, households will see that they need to rebuild their balance sheet, in this case mostly by reducing liabilities. Some Economists argue that the baby boomer generation, still very influential on the economy, is culturally incapable of saving. Both arguments have merits, and it is a tough call.

From a forecasting perspective, it is hard for the econometrician to see the factors that might drive the decision wether or not to save. The relevant factors are likely to include: household structure (married or not, kids or not), age, employment history, wealth level, debt level, type of debt, education level, and skill level.

Our forecast for third quarter GDP, 0.6 percent, was really low, and much of the error stems from our consumption/savings forecast. Our forecast presumed a similar savings rate to second quarter, and thus a very slow consumption growth rate. Given that it is difficult for me as a forecaster to see the above-mentioned savings-decision factors, I am not sure if my forecast was based on what was more likely, or if it was simply what I hoped.

Most indicators of household debt indicate to me that debt levels are still too high. As a result I hold to my belief that long-run United States economic growth will rise if households save now, i.e. pay off their liabilities. However, I am not sure if or when this will happen.

Productivity used to have a cyclical component. It fell early in a recession, and it rose early in the recovery. The early-recession fall resulted from falling sales and no employment change. The idea is that businesses see the sales decline, but don’t know if it is temporary. So, they don’t layoff for a while and productivity falls.

The early-recovery productivity growth is similar. A business sees increasing sales, but is unsure if it is permanent. So, they avoid adding to payroll until they are confident that the higher sales will be maintained.

All that went away with the past two recessions. In these recessions, productivity growth was relentless, increasing quarter after quarter. Consequently, our models cannot effectively use the new productivity information. (Don’t ask why. It is a statistical answer.)

Some, very few actually, are discounting the new jobs data, because it included the Verizon strike. We note that it also included the return of Minnesota’s government workers, significantly reducing the Verizon impact.

There are other reasons to be concerned about the new jobs data. A big one is that the previous two months were revised down. June was revised down 26,000 jobs (56 percent) to only 20,000, while July was revised down a whopping 32,000 jobs (27 percent) to 85,000. These revisions imply that the initial estimate is currently biased high, implying in turn that we actually lost jobs in August.

The combination of falling productivity and job losses is a powerful indicator that the second dip may be here or coming very soon.

Downward revisions to United States gross domestic product (GDP) have driven most of the revisions. For about two years, we had trouble with the original GDP estimates. Our jobs forecasts were pretty accurate, but we forecasted productivity growth and consumer spending growth below the initial estimates. This caused us enough grief that we’ve been reviewing our models. Well, the revised numbers are entirely consistent with our original models.

Downward revisions to productivity growth and consumer spending are what drove the downward GDP revisions.

Enough bragging. What is happening to the economy? We’re seeing a weak recovery.
Increasing numbers of forecasters, spooked by weak numbers and downward revisions, are now forecasting a double-dip in the near future. We don’t think that is the most likely case.

We’ve said all along that this would be a weak and inconsistent recession, and that appears to be what we are seeing. Some encouraging data might come in this week. The next week could see weak data. This is exactly what we expect to see in a recovery where financial institutions are wounded, real estate is weak, and consumers over extended.

So, we don’t expect a double-dip recession. We expect continued slow growth, accompanied by weak real estate markets, weak consumer spending, slow job growth, and persistent high unemployment.

That would be the good news and the bad news.

Another recession is in our future though, and not just because the business cycle has not been repealed. However, the timing of the next recession is really difficult to forecast, because in part, the timing will probably be politically driven.

I have become convinced that the culmination of Europe’s problems will be a partial breakup of the Eurozone. Perhaps it will be complete breakup. It really doesn’t matter.

Any breakup will almost surely be accompanied by financial and political crises. These crises will initiate a new recession, one that will be impacting an already weakened economy. It’s likely to be very painful.

Downgrade

On Friday, August 5 after the market close, Standard and Poor’s (S&P) announced a downgrade of U.S. Treasury debt from AAA to AA+. This announcement followed Congressional approval of a debt limit increase and ten year plan to cut projected deficit relative to baseline by $2.1 trillion. Evidently, the debt deal was not convincing evidence to S&P that Congress and the Administration were serious about corralling ballooning budget deficits. Indeed, the S&P release noted their view that “the effectiveness, stability, and predictability of American policymaking and political institutions have weakened” as a key factor in the downgrade.

The market reaction was swift and severe. On Monday equity markets moved down sharply. Interestingly, Treasury yields also fell sharply, even though they had already fallen the week before on fears of continued economic weakness. Perhaps the strength in Treasury prices still reflects a flight to quality. AA+ is worse than AAA, but there are very few AA+ investments around.

The long-term consequences of the downgrade are likely to be widespread, in large part because many large portfolios of assets are managed under ratings mandates. For example, a quality bond fund may stipulate that the average rating will be no worse than single A. Also, many funds along with banks and insurance companies are mandated to own no securities that are not investment grade. Thus, the downgrade will have consequences for many other types of debt. Securities that are currently rated AAA due to express or implied guarantee of the U.S. Treasury, like FHA/VA or agency mortgage backed securities (MBS), will presumably be downgraded as well. The average ratings of portfolios holding trillions of dollars of assets will be affected. Portfolio managers will be forced to sell their lower rated holdings and to purchase higher rated bonds, like Treasuries (still the highest rated security around, even after the downgrade). This could be another reason why Treasury yields are falling even as their creditworthiness is being called into question.

Wakeup Call

The response from the Administration was to attack the S&P methodology and conclusion. But even if the credibility of the ratings agencies is not what it used to be, the S&P downgrade and threatened downgrades by others may serve as a valuable wake up call. The current and projected budget picture in the U.S. is awful and the willingness to address it is not apparent.

Republicans point to the rise in federal government spending to GDP from 20% in 2007 to 25% in 2011 as the primary culprit. The $750 billion TARP and $800 billion stimulus seem to have become embedded in the budget baseline along with projected growth rates in spending averaging 5% over the next ten years (this is even after the latest budget deal). With nominal GDP expected to grow at a 5% pace (this is the S&P assumption), the ratio of government spending to GDP will stabilize around 25%. The Republican plan is to lower the growth rate of spending below the growth rate of GDP, thereby gradually reducing the ratio of spending to GDP and eventually bringing it back to the historical average of 21%.

Democrats claim the Republican plan is folly. They argue that aging of the American population necessarily means rising expenditures relative to GDP and the key to resolution of the deficit issue is to raise tax revenues. Over the past 50 years, federal tax receipts have averaged 18% of GDP, but this ratio has declined to 15% due to the Great Contraction (with actual GDP currently running 10% below potential GDP). As the economy improves, the tax share will probably rise back to its historic norm. But this is not enough to accomplish budgetary balance according to the political left, inasmuch as spending should be increasing more rapidly than GDP. The solution is higher tax rates and closing tax loopholes. Can this approach work?

The country needs to come to a consensus regarding the proper role of the federal government in the economy. There is room for reasonable people to differ on this issue. No one argues that federal spending should be zero, but some argue it should be in the range 10-15% of GDP. Others believe that the federal government spending should constitute 30-40% of GDP. My view is that economic growth will probably be stronger the closer the government spending share is to 15% than 30%. On the tax side, I would favor a broadening of the base and flattening of the rates. The target revenues should be established so as to match the amount of spending. We need a national debate on the proper size of the federal government.

Why do the ratings agencies have so much power?

If the S&P downgrade pushes Congress to seriously address looming budgetary issues, then it may have been a good thing. But it does raise another question, why do the major ratings agencies have so much power? They have missed nearly every major credit blow up in the past, and some argue constituted one of the primary factors driving the financial crisis of 2007-2009. By assigning AAA ratings to thousands of tranches of mortgage backed securities, S&P and Moody’s supported final demand for these securities and enabled underwriting standards to continue to weaken.

Some argue that the incentive structures were at fault in that the agencies were paid by the issuers of the securities rather than by investors in the securities. Another problem is that ratings agency ratings are built into too many investor mandates and are too deeply embedded in bank capital requirements. Both of these issues should be addressed. We should strike references to ratings in investor mandates and bank capital regulations and we should eliminate the ratings oligopoly currently cemented by SEC and bank regulations.

We believed that the United States economy, absent some outside shock, would slowly accelerate.

Today, we’re not so sure.  As Dan says, “Today, we know more about the truth.”

We have to run the new data through our model to be precise about the prospects for a new recession, and we’ll be doing that soon.  In the meantime, you have to believe that this is a very risky time for our economy.

This should cause Washington to be more determined to extend the debt ceiling.  Perceptions of the risks of a new recession have increased.  That makes it more likely that Washington will be blamed if they do not raise the debt ceiling.

At the same time we have had other measures of economic performance that have been dismal. The housing market is one high-profile example. Most other real estate categories are as weak as the housing sector. Banking is hardly better, with 365 closures since the crises began and 13 closures in April this year alone, which is a recent monthly high. Bank chargeoffs continue to maintain the blistering pace of over $40 billion a quarter. The labor market has been horrible, with weak job gains and high unemployment levels. Finally, household debt levels are still too high.

To some extent I can reconcile these differences. The positive results have been driven mostly by larger and corporate company results. The negative results are mostly a reflection that small companies have not been able to grow since early 2008. We understand the gap between large and small businesses has widened. This is due to increased regulation and tighter credit markets, which hurt small businesses much more than large corporations.

However, to another extent I am confused. I had hypothesized in 2009 that households would rebuild their balance sheets to pare down debt. However, this has not happened. This particular aspect of the economy is hard to forecast and has significant implications. It can be boiled down to this: will the household sector savings rate be maintained at a high enough rate to bring their debt levels down or not? This leads to an economic policy question: should Federal economic policy add the goal of incentivizing household savings?

Forecasting is a challenge in rapidly changing times, and these are very rapidly changing times. At the beginning of the year, it would have been unbelievable if someone had said that Mubarak would be deposed, we would be in a war in Libya, and there would be general uprisings throughout the Middle East, and all in the first quarter. But all this and more happened. Certainly Japan’s earthquake, tsunami, and near nuclear meltdown were unpredictable.

Because of the uncertainty, it seems particularly important that we provide our assumptions to forecast users. First though, you should know that we have included the impacts of the of Japan’s tragedy as best we can. We assume that their exports to the United States will fall only minimally, while their imports will increase. We also take the aggressive assumption that they will complete rebuilding in only eight years, increasing world gross product and demand for United States exports.

There are other issues with Japan that we cannot model. Because of our integrated world economy and just-in-time inventory management, Japan’s manufacturers may be suppliers of critical components of products that are ultimately produced almost anywhere. To the extent that rolling blackouts and other infrastructure issues interrupt Japan’s manufacturers’ ability to promptly deliver critical goods, worldwide production could be hurt. It is impossible to know exactly how important this is, but we believe it will be small relative to world output.

High oil prices pose the most real and immediate risk to United States economic growth, but forecasting political changes in the Middle East is impossible. But of course, oil prices have huge economic impacts. While it seems to be general consensus that the Great Recession’s proximate cause was financial in nature, Jim Hamilton at UC San Diego provides very compelling evidence that high oil prices were a significant contributor.

For our baseline forecast, we assume that world oil prices do not exceed $120 barrel. We also provide an alternative scenario where prices reach $150 per barrel. This scenario generates another recession. The recession appears to be moderate, but we must remember that this is a change in output from a low base. Our unemployment is still very high. The higher oil prices go, and the faster they rise, the worse the recession. Certainly, the forecasts of potential oil prices go much higher than $150 a barrel. Our scenario is thus only suggestive of the economic impacts of general Middle East turmoil.

United States and world financial institutions are still not recovered from the crisis of September 2008, which implies a susceptibility to new financial shocks. For our forecast, we assume no new significant financial shocks. However, the possibility of new financial shocks cannot be ignored. The possibility of some sort of Eurozone crisis arising from the sovereign debt issues of several European countries is relatively high. It is our opinion that the Eurozone is too large to be a single currency. Ultimately, it must break up. How the breakup is accomplished will have major economic consequences.

Problems in United States’ municipal markets could also provide a problem for our already-weakened financial sector. States and local governments are facing very serious financial challenges, and it appears that citizens are unwilling to increase taxes sufficiently to solve those challenges. Unfortunately as we have seen in Wisconsin and elsewhere, the other option, shrinking government, is a very challenging business.

These sorts of risks have been with us for some time, and we have previously provided scenarios of a new financial crisis. Suffice it to say, that a new financial crisis would cause another serious recession.

After having assumed away, justifiably we think, the most frightening options, we still come up with a soft forecast. It is better than we’ve seen over the past few years, but this recovery is far less robust than most, held back as it is by still-weak financial institutions and real estate markets.

We expect United States economic growth to be positive, but annualized quarterly economic growth rates (GDP) will likely remain well below three percent throughout most of 2011.

We expect job growth will be even weaker, with barely-above-one-percent annualized growth rates. This rate is insufficient to significantly reduce unemployment rates, if labor force participation rates remain unchanged.

However, we’ve seen steadily declining labor force participation, to the lowest level in decades, for several quarters. This is a result of the discouraged worker problem. Millions of Americans have been out of work for extended periods. Eventually, many of these workers just give up and leave the workforce. Those who do not give up face increasingly difficult challenges in finding a job, as human capital deteriorates of becomes obsolete.

Productivity growth continues to impress. In recession or not, United States productivity has shown remarkable strength. The trend has been strong enough to outweigh the cyclical impact for each of the past two recessions.

Productivity growth has been cited by some as a reason for our high unemployment. This cannot be true. The history of the world since the industrial revolution has been one of increasing productivity and increasing jobs. Rather, weakness in jobs is a result of a weak small business sector (see the Economic Activity essay) and structural changes. Some industries face real challenges filling open positions, while millions are unemployed or underemployed. Medical care has continually seen job gains, while millions of construction workers have been displaced. It takes time to turn a construction worker into a healthcare worker.

All this is to say that it looks like the recovery will continue to be soft and fragile. We expect to see job growth, welcome job growth after years of decline, but many challenges remain.

California remains mired in something like a zombie state, not quite dead, but certainly not vigorous, moving but with no clear direction. Perhaps, jobs and migration data best show California listless nature.

Jobs have been increasing in almost every sector, but that job growth has been anemic. We saw only 0.6 percent job growth in the past year, leaving us still down over 1.2 million jobs since the recession started. Consequently, the State’s unemployment rate remains over 30 percent above the national rate, and difference has been growing.

Similarly, California’s population has been growing, but extremely slowly compared to California’s golden past. Net domestic migration remains negative, as it has for most of a couple of decades now. Even net international migration has fallen, to less than 170,000 in 2009, the most recent year for which we have data.

Some parts of California are worse than others. California’s great Central valley is in terrible economic shape, by every measure, and unemployment rates in excess of 20 percent are not uncommon. Southern California’s once-thriving Inland Empire, Riverside and San Bernardino Counties, languishes with unemployment rates over 14 percent and decimated housing markets.

Some regions are doing better, most only modestly. San Diego, Orange County, and San Francisco are examples. Only one region the Silicon Valley is doing well enough to generate real enthusiasm. This strength is due to its famous tech sector and to the region’s high density of venture capital firms.

Sectorally, healthcare continues to lead in job creation, recently followed closely by wholesale trade. Natural resources and mining is a small sector that has recently shown strong gains, driven mostly by rising oil prices.

Local government has been California’s weakest sector, which is contrasted by the State government’s continuing job increases. Invariably, in downturns, Sacramento is able to pass most of the pain down to local governments.

California ports have been another bright spot, benefiting from California’s location on the Pacific Rim and serving as a gateway to the vast United States markets.

Of course, the logical question is: why is California’s economy doing so much worse than is the United States economy? Some will answer that California’ has had another idiosyncratic shock. This time, California was ground zero for the collapse of the housing bubble. At the previous recession, California was ground zero for the collapse of the dot-com bubble. In the 1990’s California was ground zero for the downsizing of the United States defense industry.

California has been hit with some shocks. No doubt about it. Between the shocks, however, California has also shown weaker growth, particularly outside of the Silicon Valley. This is an indication that something else is at play, something is wrong, and it has costs.

California is an expensive place to do business, but it not just taxes. The cost of operating in a state is what I call the cost of DURT: Delay, Uncertainty, Regulation, and Taxes. It is the sum of these that helps to determine a state’s job-creating competitiveness, and economic vigor. California DURT is expensive, and it is hurting the State’s economic performance. As long as DURT remains a force of reckoning in California, I expect that the state’s long-term economic structure will continue to slip away from vitality and growth.

If you are looking for a summary statistic on the United States economy, I recommend you consider bank charge-offs. These are the loans that banks have written off their books, because the probability of collecting them is so low. It doesn’t mean that the borrowers are off the hook, or that the bank will stop trying to collect the loan. It only means that a bank can’t consider a charged-off loan an asset.

Most people use GDP growth as a summary statistic for the economy, which leads to the current situation where policy makers and talking heads have declared a recovery while millions who have been unemployed for months or years continue to be unemployed. Indeed there were two recessions, based on GDP, in the 1960s where all of the job losses occurred after the recession was declared officially over.

OK, so why not use jobs as an indicator of prosperity? Actually, I’m sympathetic to that. It is certainly a better indicator of well being than is GDP. However, I think that charge-offs, particularly now, give us a little more information. Jobs tell us what businesses are doing. Charge-off data tell, at least in some sense, what business can do. That’s because banks don’t lend much when charge-offs are high, and without loans, businesses can’t grow.
So, what are bank charge-off data telling us?

They are telling us that a robust recovery is a ways off. Below is a history of real, inflation adjusted, bank charge-offs:

Prior to 2007, quarterly bank charge-offs had never exceeded $15 billion a quarter in today’s dollars. Then, they skyrocketed to almost $60 billion a quarter. Since then, bank charge-offs have fallen, but they remain well above $40 billion a quarter. You have to conclude that our banking system is still crippled.
This impacts small business much more than it impacts big business. Big businesses have direct access to capital markets and don’t need financial intermediation.

There are more reasons to be bearish on American small business growth. People who own small business own real estate, much more than the typical American. About 98 percent of all small business owners own their own home, but only about 66.5 percent of all American households own their own home. This means that small business was disproportionally hurt by the collapse in real estate values. Their balance sheet was suddenly over-leveraged, impairing their willingness and ability to borrow.

The inability of small business to use real estate equity to finance growth has impacts that are exacerbated by a banking sector that has forgotten how to lend to small business without the use of real estate as a secondary repayment source.

It used to be that small business had access to lines of credit secured by inventories or receivables. These were expensive loans, but they did not require real estate equity for the firm to grow, and in cyclical businesses they were self-liquidating, something that bankers just loved.

As real estate values climbed, banks lowered costs by moving away from these loans. Consequently, while some inventory and receivable financing remains, it is less important than it used to be. Perhaps worse, many bankers don’t know how to make and supervise inventory and receivable lines of credit. It was always a specialty. Today, asset-based lending, as this type of lending is referred to, is an almost forgotten specialty.

Still, those banks that are well enough capitalized to be aggressively seeking lending opportunities would be well advised to consider setting up asset-based lending units. It may be the only way for them to significantly increase loan volume in the near term. It would also be a service to small business and the economic well being of all of us.
The other alternative for small business expansion would be for real estate values to suddenly increase. That is not going to happen in this or next year. I go into the reasons more in the Real Estate Essay, but I have another summary statistic for you, Home Ownership Rates.

Home ownership in the United States is generally about 64 percent. That is about 64 percent of households own the home they live in. When the homeownership rate gets much above 64 percent, we have problems in our financial sector. Remember the Savings and Loan Crisis?

The United States homeownership rate climbed during the second half of the 1990s and the first half of the 2000s, until they peaked at over 69 percent. Since then, it has fallen, but not by enough. Until the United States home ownership ratio drops to below 65 percent, there will be no generalized upward pressure for home prices.

I think we have to conclude that this recovery is weak, because the normal drivers of a robust recovery, small business and real estate, can’t contribute.