The jobs report was a good one in many respects, however, the long-term unemployment level remained at the same level as in January at 5.5 million persons. This is a very large number and it is scary for those who have been without a job for a long time as research shows that it becomes harder and harder for the long-term unemployed to find jobs.

This was a sizable job-gain for a labor market that has been relatively weak thus far in the recovery from the Great Recession. The natural question now is: is this gain sustainable? We have seen 5 months of job-gains in excess of 100 thousand jobs per month and 2 months over 200 thousand. Is this enough data to make a new and stronger trend of job growth?

Or, is this strength, ever-so-welcome, temporary in the face of too many over-riding fundamental economic weaknesses? I remind the reader that during spring 2011 we had three months of greater-than-200 thousand job growth months starting in February that was followed by anemic job-growth from May through August.

At this point, I suspect that the strength is temporary. This is due to a large number of factors. Europe is still not out of the woods, Asia is still looking weaker rather than stronger, U.S. real estate is still weak, household-sector wealth is still down, household-sector debt is still high, personal bankruptcies are still high, and banking is still weak.

In this case, I would not mind being wrong.

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.

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.

The October jobs increase was below than the revised September jobs increase of 158 thousand and below the July and August jobs increases.

Construction sector gains of 27 thousand in September were largely offset by 20 thousand in losses in October. The sector that gained the largest number of jobs was Professional and Business services with gains of 32,000 jobs. Other job-gaining sectors were Education and Healthcare, 28,000, Leisure and Hospitality, 22,000, and Retail, 18,000. Other sectors were little changed.

The long-term unemployed, i.e. those unemployed 27 weeks or more, fell from 6.2 million persons in September to 5.9 million persons in October. This is a seemingly welcome result, but it actually reflects more weakness in United States job markets. The decline is due far more to discouraged workers exiting the job market than to any underlying economic strength or job growth.

The broad measure of the unemployment rate, which includes persons marginally attached to the labor force and persons employed part time for economic reasons, fell from 16.5 percent in September to 16.2 percent in October.

Today’s jobs report indicates a labor market that still remains weak, with slow job creation and a high unemployment rate. I have argued in this blog-space that significant household sector debt reduction still needs to occur to get back to a healthy economy. Debt reduction has always been, and will always be, a long and painful process, particularly when a key asset price, housing, remains low.

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.

The saga of the Great Recession continues. Over six million people have been unemployed for more than 27 weeks, and job growth may be slow enough in the next few months that the unemployment rate rises again. Major revisions to GDP, released in late July, show that from 2007 to early 2011 the United States economy was weaker than previously understood. The consensus forecasts for the United States and World economies have been revised down.

However, these aspects, negative as they are, are not currently as important to near-term growth as the impact from the probable reduction in the number of countries in the European Union. Bill Watkins discusses the European crisis earlier in this blogspace.

The economy grew much more slowly during the first half of 2011 than during 2010. One big reason is that consumption growth slowed. I think that consumption growth will remain relatively weak for at least the remainder of this year. This is in part because I think that wealth accumulation and income growth will be weak. At this point, low interest rates do not help much. But, there is more to the consumption story. Household debt levels, despite subsiding from their bubble highs, are still too high. If households continue to reduce their debt, consumption growth will remain muted. While near-term growth suffers a bit when households save more, the long-run health of the economy is improved. Economic recovery from major asset price deflation has never been quick or pleasant, and this time is no different. Indeed, real estate prices remain low and equities are down from the first half of this year.

We forecast growth in inventory investment and in equipment/software investment. However, we are bearish on commercial structures and housing.

We forecast that government expenditures growth, which includes state and local, will remain slightly negative for the remainder of this year. It appears that governments at all levels have bumped into their budget constraints.

We forecast that trade will produce a slight drag on growth, with the trade balance deteriorating slightly. This is due to slowing world growth.

What about the Fed? They have conducted the first of their two-day policy meeting today. I expect that the Fed will announce a policy change tomorrow which could include an attempt to push longer-dated Treasury rates down and, less likely, a reduction in the interest rate on excess reserves. The market has appears to have priced in a reduction in longer rates. Despite this boost, equities are not doing very well.

A reduction in the interest rate on excess reserves would provide greater incentive for banks to loan, and this is the better idea of the two. However, this policy may not provide much benefit. The problem is that many small businesses and households are reducing debt, not increasing it.

As a result of the above mentioned forecast of the major components of GDP, our GDP forecast is bearish, significantly under the Wall Street Journal consensus of 55 forecasters for the second half of 2011 and the first half of 2012.

With the recent and forecasted weak United States and World economic growth and with a slowdown in commodity price growth, our forecast indicates that inflation will not be a problem. The secular trend in rising inflation since March will likely be broken soon, probably as soon as the September data is released in mid-October.

Inflation will be the least of the Fed’s worries during the second half of 2011.

The normalized TED, which is the 3 month LIBOR minus the 3-month Treasury divided by the 3-month Treasury, has reached a level not seen since the fall of 2008. The TED, i.e. the numerator or the LIBOR minus the Treasury, is normally interpreted as a wholesale banking spread. When this rises, there is greater perceived risk to the banking sector. The normalized TED can also rise if the 3-month Treasury falls, which can happen in “flight to quality” situations, as is also the case now. This spread appears to be indicating a rising probability of a change to the European Union. We at CERF now believe that it is not if the European Union will break up, but when. However, this spread is just one of many indicators that we have watched to form this opinion.

The second chart shows the ten-year Treasury, TB10Yr, and the triple-A corporate bond rate (ten-year) and the normalized spread between these two measures. The normalized spread has almost reached levels that occurred in late 2008. This measure is also indicating a “flight to quality” in financial markets because the ten-year Treasury rate is falling faster than the triple-A corporate bond rate.

I have argued in this blog-space that these indicators helped us see the regime shift to a serious recession that occurred in late 2008. The current levels are uncomfortably close to indicating another regime shift.

Many banks and investment companies seek to attain the highest leverage allowable. If they are constrained to hold a higher capital ratio than a competitor (so that the competitor enjoys greater leverage), they will loudly assert that this gives the competitor a “competitive advantage.” If banks headquartered in the United States are required to hold capital ratios in excess of foreign banks, then it is argued that foreign banks will take over the market.

What is the basis for this claim? Why does management seek to maximize leverage? A first answer is that greater leverage means higher return on equity (ROE). Suppose you have equity of $100 and you buy an asset with a return of $6 per year. Your return on equity is 6%. Then suppose you are able to borrow another $100 at a borrowing cost of 4%. Now your total dollar return will be $6+$2=$8, and your ROE will be 8%. If you could borrow $1,000 at 4% and invest at 6% then your ROE will be 26% (the formula is ROE=Return + Leverage*(Return-Borrowing cost)). So long as your return is greater than your cost of funds, higher leverage means higher ROE.

Of course, if the return turns out to be smaller than borrowing cost, then the effect of greater leverage is to reduce ROE and possibly turn it negative. In the financial crisis, returns did turn strongly negative and many highly levered financial institutions had their capital positions decimated. In the aftermath of the financial crisis many observers have called for higher regulatory capital requirements on banks. Some have called for substantially higher capital levels. Alan Greenspan argues that the capital ratio should rise from 10% to 15%. He believes that 15% is the maximum feasible capital ratio.1 Any requirement greater than this would mean that banks could not attract capital. Financial experts at the Stanford Business School2 dispute the Greenspan logic and support even higher capital requirements. Why not 30% capital?

The answer, according to bankers, is that banks cannot earn an adequate return on equity if equity levels are increased substantially. Let’s suppose that 30% equity to assets became the regulatory minimum. The banker calculation would be something like this: depending on the type of loan, yields net of expected losses may be 4% or 5% today. Assume 5% yield and 1% cost of funds and operating expenses equal to 1% on assets. Then the pre-tax ROE will be

           (5%-1%)+2.33*(5%-1%-1%)=11%

The after-tax return would be well under 10% making the bank unattractive to equity investors.
The academics dismiss this argument. While they agree that average ROE may be lower, they assert that the required return is lower as well; with lower leverage the riskiness of the income stream is lower and so the required return is lower. Besides, if investors want more leverage, they can manufacture it themselves by buying on margin.

A hundred years ago or so, banks in the United States carried substantially greater capital than today, something fairly close to 30%. Back then banks were subject to runs during difficult times. Federal deposit insurance introduced in 1932 largely eliminated the risk of runs and made bankers comfortable with much lower capital levels. To the extent that deposit insurance is underpriced (banks are levied premiums proportional to the amount of insured deposits), deposit insurance is a subsidy and bank shareholders naturally support maximizing the subsidy.

The problem with low capital levels is that even modest loan losses jeopardize the soundness of banks thereby threatening financial stability. Economists call this a “negative externality.” Since the largest banks are too big to fail, this means the taxpayer is on the hook to bail out creditors of these banks. According to the professors, a primary benefit of dramatically higher capital levels for banks is that the negative externality is reduced and so is the taxpayer subsidy. The financial system would be much less prone to instability.

But even if you agree that the financial system would be stronger if large banks held more capital, the problem is that we have to get from here to there. Bank assets today are approximately $11 trillion and bank equity capital is about $1.3 trillion. Assuming that assets stayed the same, then banks would need to raise approximately $2 trillion of equity in order to meet a 30% equity to asset standard. If such a standard were to be imposed, it would require a very long phase-in period. Admati, et.al., assert that a clear policy implication is that regulators should prevent banks from paying dividends, buying back stock or making other equity payouts until higher capital levels are achieved. If imposed, this restriction probably would not help entice investors to buy bank stocks.

1 Alan Greenspan. On the crisis. 2009.

2 Admanti, DeMarzo, Hellwig, and Pfleiderer. Why bank capital is not expensive. Stanford Graduate School of Business Research Paper. 2010.

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.