Productivity has been the source of most of the changes. Jobs data get revised too, but we haven’t seen revisions near the size as we’ve seen for GDP, and GDP growth is the sum of employment growth and productivity growth.

Recently, the initial estimate for 2011’s third-quarter GDP growth was revised downward from a 2.5 percent annual growth rate to only a 2.0 percent annual growth rate.

Still, even a 2.0 percent growth rate represents a nice pickup from the extraordinarily weak first two quarters. Unfortunately, much of that improvement came in the form of productivity growth rather than job growth.

It confirms our judgment last summer, when we expected the Country to avoid the second dip so many forecasters expected after the August data revisions to the first two quarters’ GDP data.

That doesn’t mean we’re out of the woods yet. The probability of one of both of two very serious events that we’ve been warning about for months seems to be increasing daily.

A significant interruption in oil supply from the Middle East would have catastrophic impacts on Western economies. The probability of such an interruption is becoming alarmingly high, in our estimation.  A week or so ago, there were headlines that a natural gas line in Egypt was sabotaged, the Kuwaiti government has collapsed, and Syrian atrocities are continuing, perhaps increasing. The likelihood of an oil-supply interruption is high, and the economic impacts of an interruption are very serious. Economic recession will affect all developed economies.

The other risk is a financial crisis associated with the breakup of the Eurozone. While the markets are giddy today with the prospect of yet more Eurozone bailouts, the bailouts are only bandages.

Fundamentally, the Eurozone is a contradiction that cannot be sustained. Some countries will have to leave it. When they do, there will be losses. Financial institutions and governments will face stresses not seen since September 2008. The resulting recession will be serious and widespread.

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.

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.

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.

Dan Hamilton
October 28, 2010

The first estimate of United States third quarter Gross Domestic Product came out today. The preliminary estimate of third quarter real GDP growth was 2.0 percent, which follows a 1.7 percent growth rate during the third quarter. This preliminary estimate of third quarter economic growth is not very different from the previous quarter’s growth rate. However, one aspect of the composition of growth changed dramatically from the previous quarter, which was residential real estate investment. This measure, which grew 26 percent during second quarter, fell 29 percent during the third quarter.

I have argued in this blog-space that the 26 percent second quarter growth was a temporary, stimulus driven result, and not a sustainable recovery in residential real estate. This data release supports that argument and is congruent with our September 27 United States Economic Forecast of a contraction in this investment segment.

I should say that with respect to the recently ended recession and the currently weak recovery that we are now experiencing, “it’s the residential real estate, stupid!”, and we see continued weakness for that sector for some time. There are too many homes yet to be foreclosed on and too many unemployed that cannot consider a home purchase at this time. The stock of ownership housing is too large for demand, and it will remain too large for demand this same time next year.
Other aspects of the data release are counter to my forecast, namely stronger consumption expenditures, stronger inventory investment, stronger government expenditures, and stronger commercial real estate expenditures. Stronger consumption expenditures boost GDP now, but given that household sector debt levels are still too high, I worry about the long-term consequences of such consumption. Continued consumption growth, if it occurs, will be accompanied by rapid inventory investment.

I continue to be surprised by the strength of government expenditures. The preliminary estimates show federal spending growing with such strength to offset state and local weakness. I continue to expect that state and local expenditure weakness will be a greater drag on growth during the next few quarters than the previous couple of quarters.

Third quarter GDP was reduced by trade as was the case in second quarter, although this effect was weaker this time, 200 basis points, versus 350 basis points during second quarter. These results are driven by extraordinary import strength, which most forecasters, as well as I, do not believe is sustainable. Once this import strength subsides, GDP growth will benefit.

I do not see many fundamental support factors for United States economic growth at this time other than trade, technology, and manufacturing. However, these are not large enough to create a strong economic recovery from the Great Recession. The next couple of quarters might see offsetting factors that create moderate growth for some time to come. The positive factors will likely be: federal government expenditures, equipment and software investment, and import growth reductions. The negative factors will likely be: state and local government expenditures and real estate.

A major difficulty with forecasting at this time is the question of how households will behave during the next couple of quarters. Will they save for the future or consume? There are economists on both sides of this question. We have been thinking that they would save, and we will probably continue to forecast this.

Seeing a problem and knowing how to solve it are two different things.  So, we’re going to see lots of silly ideas proposed.  We’ll see demands for more government spending.  We’ll see demands for less government spending.  We’ll see demands for higher taxes.  We’ll see demands for lower taxes.  We’ll see demands for more consumer spending.  We’ll see demands for more consumer saving.

All of these recommendations can’t be correct.  In fact, they are all beside the point.  I’m not saying the proposals won’t have any impact.  They will, but the impacts will either be marginal or they will be some time in the future.  Our problem is immediate and very serious.  Here’s what we need to do to avoid a lost decade:

• Fix the financial sector
• Stop paying interest on deposits at the Fed
• Lower effective borrowing costs with an investment tax credit
• Reduce regulatory uncertainty and big-business bias
• Increase immigration

Any vigorous recovery needs a vigorous financial sector, and ours is not.  Fed policy has been ineffective, because the money multiplier has tanked, even as the monetary base soared.  There are two reasons for this: The Fed is paying banks to deposit at the Fed, and the banks–burdened with over-leveraged balance sheets, huge charge-offs, and bad assets–are in no shape to lend.  Fix the banks, and stop encouraging them to park money in Washington, and we’ll have a start on real recovery.

We have an investment problem; there isn’t any.  That’s because, even at zero, borrowing costs exceed expected returns on investments, and the future regulatory environment is extremely uncertain.  We can’t lower interest rates below zero, but an investment tax credit would effectively lower borrowing costs.  Do that and remove regulatory uncertainty, and our businesses will invest.  While we’re at it, let’s reduce big business’ regulatory advantage.

Finally, we don’t have any problems that couldn’t be fixed by a few million new immigrants.  We’d see an immediate increase in housing demand and construction.  Our inner cities would be renewed.  Our economy would see a burst of creativity, energy, and new business formation.

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.

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.