I argued that the United States economy is now in an intermediate equilibrium, one I call the “good-deflation” equilibrium. This is where consumers see low price growth as helpful in maintaining moderate spending in a jobless economy, producers see low price growth as helpful in maintaining costs, and the FED is able to maintain historically low interest rates without worrying about inflation.

What are the factors that might drive an equilibrium shift from today’s good-deflation equilibrium to a bad-deflation equilibrium? We need factors that measure how people feel. We would like to know how households view their current economic situation, how firms view their current situation, how banks view their situation, and how investors might view the future.

Prototypical measures of these items are: the consumer confidence index, the business sentiment index, the Ted spread and/or the normalized Ted spread, and interest spreads such as the Baa–Aaa or the Aaa–TB10Yr. The Ted spread is the 3-month LIBOR minus the 3-month Treasury, and the normalized measure divides the Ted by the 3-month Treasury. We show pictures of these measures in graphics below.

Interestingly, financial market measures clearly show late 2008 and early 2009 as being times of regime shift, whereas the various measures of consumer and business sentiment do not show this as clearly. I believe that based on these indicators and on broad measures of economic activity like GDP and jobs that the United States economy shifted to an equilibrium characterized by freezes in credit and risk-taking in the fourth quarter of 2008. In the third quarter of 2009 the economy shifted to better equilibrium, one still in force now. This is the intermediate “good-deflation” equilibrium discussed earlier.

What do these indicators tell us now? The blue line consumer confidence measure on the Consumer Sentiment graphic fell dramatically every month from July 2007 through 2008. Since then, it has remained flat at a very low level. This might not be a good sign. The various credit spreads indicate that conditions are much better now than they were in late 2008, but conditions have not returned to normal.

Both of the bond spreads shown here have been climbing rapidly for 2 months. If this continues many more months we would have a key indicator telling us that those market conditions were changing or had changed to a worse equilibrium. This would not necessarily mean the entire economy had changed. I would be more convinced the entire economy had changed or was changing to a bad equilibrium if all of the indicators move dramatically in that direction.

I urge our clients to watch these indicators. I will monitor them, and provide occasional updates in this blog-space.

The most fanatical Keynesians are losing their composure. Brad DeLong, a prominent Berkeley economist and Keynesian, is virtually yelling that “We Need Bigger Deficits Now!”, emphasis his. Paul Krugman does DeLong one better, calling proponents of fiscal responsibility madmen.

They are following the gospel of John Maynard Keynes, who famously advocated government deficits to pay people to dig holes, increasing demand and therefore economic activity. This is, to be polite, bunk.

It is worse than that actually. The logic implies that any government expenditure funded by debt will result in sustained economic growth. The result has been a stimulus plan that completely lacks coherence. Instead, we have a hodgepodge of spending initiatives that provide a temporary illusion of growth, but that will leave us with little that is long-term, except for huge hangover of debt which will be a drag on economic activity for years.

Keynesian stimulus theory comes about because of what is called a liquidity trap, a situation where the interest rate is zero, because no one wants to invest. The logic is that you can spend your way out of a liquidity trap; that by spending, government can increase sales. Eventually the increased sales will cause businesses to invest, driving interest rates up.

It is an article of faith among Keynesian economists that if the stimulus is big enough, it will generate sustained long-term growth. Call this the Tinkerbell Principle. You only have to believe in animal spirits to have expectations of a better future.
Consequently, when the spending doesn’t achieve the desired result, Keynesians always call for more deficit spending, just as we see in the above-linked DeLong and Krugman arguments. And, when that doesn’t work, like a broken record, they will call for more, but there can never be enough.

There is a case to be made for expectations, but they need to be rational. The recession was similar to a bank run, which can kill a bank, even when there is no initial weakness to generate the run. In this case, we had a run on the world’s financial system. Call it a regime shift from a good equilibrium to a bad equilibrium.

Can government spending alone bring us back to a good equilibrium? It can if you believe in animal spirits, but I don’t.

I believe that people are not excessively stupid. Economists call this concept rational expectations, the idea that most people can see obvious consequences most of the time.
I believe that people spend out of wealth: the value of the assets they hold and the present value of future income. This may not be an easily calculated number, but people keep track of it. It is something like a fielder’s response when a batter hits a ball. This is a complex problem, but fielders respond instantly. The fielders are moving in the correct direction at the correct speed to intercept the ball while the bat is still in motion.

Finally, I believe that people try to smooth consumption. That is, they like to eat a little every day rather than go without for several days and binge on other days.

Let’s analyze typical deficit-financed government spending programs using these beliefs. Somebody is going to have to repay the debt someday. It can be the person who receives the money, some other person who is currently working, or some future worker.

If the person who receives the money is the one who must repay it, she will normally save it. Her wealth has not changed, she knows that she will have to repay the money, and she’s not excessively stupid. She’ll want the money there when she needs it. We saw this with the Bush “tax rebates.” Consumers saved the rebates, and the administration did not see the consumption boost they had anticipated.

There is another possibility though. She could be what we call ‘liquidity constrained’, holding no cash and unable to borrow. Her wealth is still unchanged, but she wants to smooth consumption — keep it at a relatively steady level — so she may spend some or all of the money. However, this implies that her future spending stream will be reduced. We’re taking from tomorrow’s economy to support spending today. This may be justifiable on humanitarian grounds, but it doesn’t generate sustained long-term economic growth.

Suppose it is another worker who will repay the government debt. His wealth has just decreased. He’ll spend less, and, also being a consumption smoother, he’ll start spending less right now. Again, there is nothing here to generate sustained long-term economic growth.

Finally, suppose it is some future worker who will repay the debt. He or she will enter life or the workforce with a debt. I’ll ignore the ethical implications of enabling increased consumption by current citizens by imposing, without consent, debt on future workers; instead, I’ll stick just to the economics.

Our future worker starts a career, absent some other endowment, with a negative net worth. Over the course of his career he’ll spend and invest less than if he had started with a zero net worth. Again, this is not a prescription for sustained long-term economic growth.

What we have to face is that by borrowing to consume now, we are taking away from the future. This is just not the way to achieve sustained long-term economic growth.

So what to do if you are a politician who thinks something must be done?

The liquidity trap comes about because no one wants to invest. What government should do in response is try to increase demand for investment. This would increase economic activity now and in the future. Increased demand for investment can be created by investing in public capital that makes private capital more productive, and by lowering the cost of borrowing.

When the government borrows and invests the money in projects that increase private capital’s productivity, it is increasing the return to capital. Increasing returns to private capital increases the demand for private capital and investment. Current and future economic activity is increased.
We have lots of examples of these types of investments, including canals, dams, highways, public utilities like the Tennessee Valley Authority, and more.

The other approach to increasing investment is to lower the interest rate. This is difficult to do directly when the interest rate is zero, but the government can achieve the same result another way. An investment tax credit effectively lowers investors’ borrowing costs.

So, if the government is going to actively stimulate the economy, it would be far better to invest in public capital that improves the returns to private capital. It will also help to provide a meaningful investment tax credit. Consumers could then rationally expect their future income stream, hence their wealth, to improve. With increased wealth their spending will increase, and we will be on our way to sustained long-term economic growth.

A year ago we were hearing all about green shoots. Analysts claimed to find them everywhere.
Today, we never see the term. In fact, there seems to be a growing malaise. By the end of June the first quarter’s Gross Domestic Product (GDP) estimate was revised downward a full half a percent, to 2.7 percent. Pundits are depressed. Our President and Secretary of the Treasury are telling the world that the United States cannot lead the world to sustained economic growth. Our Vice President announced that “there’s no possibility to restore eight million jobs lost in the Great Recession.” Our stock markets are down and volatile. Risk premiums have soared.

What happened?

Reality happened. The green shoots were always ephemeral, the result of massive government spending increases or temporary government programs. We had housing stimulus programs. We had Cash for Clunkers. We had foreclosure programs. We had bailouts.

The increased spending and the various programs had an impact. Because of the way GDP is calculated, an increase in government spending results in an increase in GDP, but that is today’s GDP, not tomorrow’s. Tomorrow’s economic growth is a result of investment today, investment in physical capital, technology, and human capital.

To the extent that government spending detracts from those investments, the growth we saw was cannibalized from the future. For example, the housing stimulus programs served only to change the timing of real estate purchases. Sales fell when the programs ended.

Even worse, some programs resulted in temporary GDP growth, but were actually detrimental to long-term economic growth. The Cash for Clunkers program destroyed capital, since perfectly good cars were crushed. The foreclosure prevention programs delayed the needed decline in home ownership rates.

The bailouts prevented assets from being transferred to more productive uses. Bailouts are inefficient, and they prolong periods of economic weakness. Uncertainty and risk premiums remain elevated, holding investment to a minimum, limiting short-term and long-term economic growth. They also leave a hangover of debt, which limits future growth.

None of the programs addressed the underlying problems of the current economic circumstances, or paved the way for sustained economic growth. The immediate problem was that businesses, consumers, and governments were over-leveraged after September 2008’s asset-value collapse. The longer-term problem was insufficient investment, a result of years of credit-fueled consumption.

What was needed was investment. What was provided was more credit-fueled consumption. You might be able to borrow your way to prosperity, but to do that you better be investing the borrowed funds. We didn’t do that. Instead we used the government as a bank to increase consumption. Credit-based consumption is not the way to long-term prosperity, regardless of who does the borrowing.

And, while it appears that most of the decline in asset values has ended, over-leverage is still with us. Indeed, the increase in government leverage makes it more difficult to employ effective government intervention, government investment in productivity-enhancing capital and technology, and investment tax credits.

Add to these factors the millions of American households, employed and unemployed, that remain over-leveraged. Millions of consumers have been unemployed for months, and many of those still working are uncertain about their future employment. Those who have the income to do so are attempting to pay down debt, and to reduce consumption in the process. The consumer is not likely to soon be a source of rapid economic growth.

So, we have most or all of the problems of a year ago, but now, because of increased government debt, we have fewer options. Even worse, we now have new problems that were not present in September 2008.

Today, sovereign default risks are significant and increasing. While potential sovereign debt problems in Europe have received a great deal of attention, the problems are not limited to the continent. Japan continues to have very high debt and deficits. Several U.S. states could also default. A failure of an American state is likely to have impacts very similar to the failure of a small European country.

I don’t believe that the failure of a country is the most likely outcome, however. Instead, expect to see more international bailouts, just as you can expect to see the federal government bailout several American states.

Our options are limited, but we do have one option that would provide immediate and sustained economic growth without increasing leverage. That option would be a massive increase in immigration.

The initial benefits of a new wave of immigration would be seen remarkably quickly. Housing demand would increase, leading to renewed vigor in our real estate markets and the construction industry. Our inner cities would be renewed, as they always have been by immigration waves. New business formations would soar. The tax base would increase, helping to fund debt repayment and baby-boomer retirements.

Many would oppose such an immigration increase. They worry about increasing job competition, unemployment, crime, and even more demand on welfare programs.

These fears are misplaced. Criminals are easily sorted out by effective screening processes. People don’t migrate for welfare benefits, but if this is a concern, it is easy to deny immigrant access to social programs for some number of years after immigration. Similarly, people don’t migrate to be unemployed, and unemployment benefits can be denied to immigrants.

People migrate to more effectively use their human and physical capital, their technology, and their labor. Effectively, immigration would provide new capital, technology, and labor. This is exactly what we need, and it is free. Immigration has served America well in the past. It can serve us well today.

Most of the June PPI deflation was due to declining food prices. Producer prices are up from a year ago, where of course a year ago, prices were at record lows after being pummeled by the Great Recession.

Monthly consumer price growth has also been negative since April, while year-on-year CORE consumer price growth has been falling since December of 2009 and is at a 49-year low.

These price changes are occurring against the backdrop of contracting Retail spending and slowing manufacturing growth, according to the latest (June) data.

We teach our students about multiple-equilibria, especially in the context of macro and international models. The typical cause of multiple equilibria, as opposed to a unique equilibrium, is alternate expectation possibilities. In certain situations, agents’ expectations might easily change from one possibility to another.

Think of an over-simplified condition where three equilibria are possible. The best equilibrium is one that would be difficult for the United States economy to achieve at this time, one where job growth was 1.5 percent, GDP growth was 3.5 percent and inflation was 2.0 percent.

Another possible equilibrium could be one where deflation strangles the economy, where debt-laden and cash-strapped consumers decide to hold off on purchases thus causing a large fall in the 71% component of GDP that is consumer spending. This is the worst of our three possible equilibria, and the one that causes economists to lose sleep at night.

A third possible equilibrium, an intermediate one, is where consumers see low price growth as helpful in maintaining moderate spending in a jobless economy, producers see low price growth as helpful in maintaining costs, and the FED is able to maintain historically low interest rates without worrying about inflation.

The third possible equilibrium is, in part at least, a result of technological improvement. Any $1,000 dollars spent today on a personal computer, or any $100 dollars spent on a cell phone purchases the consumer a product that is dramatically more functional than what was available just a few years ago.

I believe that, at the moment, we are in a situation that is essentially the third equilibrium. Absent some unforeseen event, the possibility of achieving the first equilibrium seems remote for now. The possibility of achieving the second equilibrium is unfortunately all too high.

My hope is that we stay in this relatively desirable intermediate equilibrium, but of course there is no guarantee of this. The factors that drive an equilibrium shift, including today’s lower consumer confidence data, will be the topic of another blog.

We here at CERF had been worried that, during the fourth quarter of 2009 and the first quarter of 2010, much of the observed growth transitory. We believed at that time that the household sector should have been rebuilding their balance sheets, reducing debt, and restraining consumption. It appeared as if government programs were inducing households away from balance sheet rebuilding with incentives to spend, to the long-term detriment to the economy. These programs included Cash-for-Clunkers, Home-buyer incentives, and attempts to save flagging mortgage payments.

We now have indication that late 2009 and early 2010 spending was temporary in which case it was in fact future consumption that was moved forward. If so, then we can expect weak retail sales in the next couple of months as well.

The unemployment rate drop is attributable to a labor force decline that outweighed the job decline. The June labor force decline continues a decline from last month that is an offset to labor force gains in the previous four months. In the past six months the labor force rose 1.7 million persons from the December 2009 low, then fell by about 1 million people in the last two months. These imply that the current labor force level is still about 700,000 people above the cyclical low. If it is true that the recent labor force increase was an unsustainable blip, then we might expect another labor force decline next month.

If next month’s expected labor force decline were similar in magnitude to the employment decline, the unemployment rate would remain essentially unchanged. One reason to expect an employment decline next month would be due to an ongoing contraction of temporary Census workers. The remaining temporary Census worker count is roughly 250,000 jobs. We expect the July labor force decline to outweigh the employment decline, but to less extent than this month, resulting in another unemployment rate decline.

The private-sector employment change was mostly driven by declines in Construction, Information, and Finance more than offset by gains in Manufacturing, Professional services, Education/Healthcare services, and Leisure/Hospitality services. The gains and losses in Manufacturing and Information, respectively, are small and offset each other.

The June gain in Professional services of 46,000 workers is welcome in this barely-a-recovery recovery. These are helpful because they are typically well-paying positions that will benefit the recovery better than low-paying positions. The Leisure/Hospitality gain is the first significant gain in this sector thus far in this cycle. This gain is dominated by amusements, gambling, and recreation, so aside from Casino cities, the gain may not be consistent with stabilization of rent and lease trends in most restaurants and hotels.

Our back-of-the-envelope July job change projection would be driven by a presumed Census worker contraction of 230,000 that would be offset by private-sector gains of 80,000 resulting in an overall 150,000 non-farm job drop. If the employment survey drop matched the job drop and the labor force contracted by 300,000 then the unemployment rate would be a bit over 9.4 percent in July.

Comments about this month’s survey: First, the consensus as measured by this survey is more pessimistic this month than last month, especially for 2010. This month, 56% percent of the panelists are projecting negative 2010 home price growth, up from 40% last month. The other interesting about the results is the dispersion of opinion across panelists. The difference between the most optimistic and most pessimistic projections imply a difference of roughly $14 trillion in United States real estate value by the end of 2014. The resulting impact of this difference on macroeconomic forecasts of GDP, consumption, housing starts, and many other key indicators would be large. Finally, a back-of-the-envelope calculation from the chart provided in the press release link above shows that at the height of the bubble in 2006 the average United States home was over-valued by about $65,000. It is likely that the average California home, especially single-family home, was over-valued by more than the U.S. average.

Regarding forecasts of the United States, California, and Oregon economies: I find it interesting that, on average, our competitors are slightly pessimistic relative to us with respect to the housing price outlook, but noticeably more optimistic than us on economic growth. They must believe that households and firms will be happy to spend this year despite the fact that housing is not likely to recover. We disagree with this, believing that a sustained recovery will require more improvement in the housing market.

The FDIC reports that 83 banks have been closed so far this year. While there were 140 bank failures in 2009, we are on track (based on a simple extrapolation of current trends) to experience at least 160 bank failures in 2010. This is down from my month-ago extrapolation of 180 failures.

These failures are occurring while the Fed is paying interest on excess reserves, which has the effect of removing or tightening credit in the banking system. One would think that in this recessionary environment the Fed would implement a credit relaxing policy rather than a credit tightening policy. Rather, the Fed is pursuing this policy because there are a lot of banks out there that they are worried about.

The three month Libor rate has remained high, indicating that banks remain worried about the credit worthiness of various institutions around the world. See the chart below.

This is bearish news for the United States economy, but I bring something more important to your attention. From the chart below, you can see that in the year 2000 the United States typically experienced housing starts at the one and a half million home annual rate. This was pre-bubble, the bubble-rate during 2005 and 2006 was about 2 million starts. At least as important, the United States economy has been mired in the low housing start level of 500 to 600 thousand since November of 2008 with no sign of breaking out of this regime.

Our United States GDP forecast for each of the remaining quarters in 2010 is approximately 100 basis points below the consensus forecast. This measure of economic activity is partly why our forecast is bearish, other reasons include weakness in the Household sector’s balance sheet, and on-going problems in banking. I ask this question for my competitors, the other forecasters who in the aggregate are the consensus, how could real GDP growth be three percent when housing starts remain this low?

Building material purchases dove 9.3 percent following an 8.4 percent jump in April (and an increase in March). Government appliance rebates and the homebuyer credit programs are the source of this sector’s volatility. General merchandise sales declined 1.1 percent, the largest decline since December 2008.

May motor vehicle sales were down from April despite auto manufacturers’ reports that May was up from April. This may indicate that car dealers are building inventories, almost surely involuntarily.

Half of the total Retail sales dollar volume change was due to the decline in Building materials, which was a short-term response to a change in government incentives. But there may also be a conscious effort on the part of the household to increase savings. Continuing a theme I wrote about yesterday, additional savings, while implying weaker second quarter GDP growth, would pave the way for a more sustained recovery in 2011.