Saturday, June 07, 2008

The non-recession continues

More evidence continues to appear that the US economy, while struggling, is not in or headed into a recession. The first-quarter annualized growth rate has been revised upward to +0.9%. Employment has continued to rise, although very slowly.* Retail sales have been doing better for several months. Exports are rising strongly, boosted by the cheaper dollar.

That's not to say that parts of the economy aren't in serious condition. The picture continues to be very mixed, with housing and related sectors (construction, finance) doing poorly. The strength of other sectors is currently enough to compensate.

Housing remains the major sore spot. It's sometimes called a "crisis" (what doesn't the media label a "crisis"?), but the collapse of the recent housing bubble is actually the end of a crisis, the crisis of housing unaffordability. Something big has changed: what's ending is the long, demographics-driven 35-year housing boom, the era in which rising house prices practically guaranteed "house = piggy bank." That is a shock to people who planned on housing prices rising at unsustainable rates forever.

The trouble in the housing sector can be gauged in one way by the supply available. In healthy times, the housing stock available for sale is about a four- to six-month supply. Right now, it's about 11 months and still climbing. The housing bubble implosion won't be over until that last number starts dropping.

Should there be a government bailout of the housing sector? No. It's especially important that falling prices be allowed to seek a new equilibrium, rather than attempt to hold them up or bail out the housing construction sector. That will only prolong the backlog of unsold houses. There is a case for a more limited government buyout of low-income housing buyers who were suckered into buying houses by cheap credit and government-sponsored enterprises (GSEs, like Fannie Mae). Government itself played a large role in converting what, under any circumstances, would have been a housing boom anyway into occasional bubbles. There was a brief housing bubble in the late 80s and another, much larger one recently, both sustained by spurts of low interest rates from the Fed.

The bubble clean-up should be treated as the savings and loan clean-up was in the early 90s. That too was the aftermath of a government-enabled bubble. The Federal Reserve responded by encouraging banks to buy out the S&Ls. Congress made one-time payouts to the depositors hurt. At the same time, the S&L industry itself was phased out and a new regulatory structure put in place that limited the government's exposure to bank deposit insurance risk. It would be hard to guarantee that a future Fed won't again flood the economy for sustained periods with cheap credit in order to allay recession fears. What can be done, however, is to phase out agencies like Fannie Mae and Freddie Mac. They're obsolete relics from the 1940s and 50s, before the rise of the modern mortgage industry.



Some observers have pointed to inflation as a much more serious threat than recession, and Bernanke seems to have shifted closer to this view. Certainly the evidence so far supports it. We've seen jumps in raw material and food prices reminiscent of the early 70s and the Great Inflation. As it was then, a falling dollar is a major factor.

At the same time, there are strong countertendencies not present back then. The drop in housing prices, which will continue for at least another couple years, is one. Productivity and export growth remain strong. There is no push upward on wages and salaries beyond what productivity growth can sustain. All these factors are strong inflation dampers. What we're likely to see in the next few years, therefore, is a limited-inflation environment punctuated by brief but sharp, repeated raw materials price changes. This is a "price shock" environment that economists talked about so much back in the 70s, but without the structural factors that promoted sustained inflation.

Still, it's disturbing that tendencies from the Nixon-Carter era long thought dead have re-appeared: chronic inflation, weakening dollar, raw materials price shocks, the specter of "stagflation." The combination of a large surge in government spending and loose monetary policy, resulting in bubble and bust, is the culprit.
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* It might seem like a paradox, since the unemployment rate increased three of the last five months. But the unemployment rate isn't just people laid off; it's also people looking for work. The latter group has surged in the last couple months, as people neither employed nor looking for work have re-entered the job search pool. The economy hasn't been growing fast enough to absorb all of them into jobs.

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