Sustainable Growth?, by Tim Duy: October is becoming my lost month. Between the beginning of Fall term and my annual conference in Portland, the month is a blur, and time to blog becomes a luxury. Now, however, I can see the light at the end of the tunnel. And we can also see the light at the end of the tunnel after this long recession, with a GDP report that confirms what everyone thought - the economy turned the corner in the third quarter of this year. Policymakers undoubtedly breathed a sigh of relief, and rightly so. That said, it is far too early for complacency; I found the underlying details less than comforting, especially in comparison to Wall Street's ebullient reaction to the data.
That the recession would end was never in doubt. Indeed, the timing is almost exactly what one would expected given the steep declines in spending in the first half of 2008 that triggered the flood of job losses later in the year. Spending, consumer spending most importantly, would not fall indefinitely, especially with the benefit of significantly lower energy costs beginning in the second half of last year. Moreover, as the Wall Street Journal notes, rebuilding household balance sheets is not accomplished by just increased savings; a default can do the job much more quickly, quickly adding to household cash flow. Indeed, I admit to being surprised that strategic defaults are not much higher.
The more important question is what will be the durability and sustainability of the recovery in the years ahead? The GDP report raises some significant red flags when considering this question. The consumer spending number was clearly goosed by the Cash for Clunker program and a much slower pace of inventory depletion than expected, which combined to add almost 2 percentage points to the headline figure. But auto sales have slipped back under the 10 million mark in September when the Clunkers program ended, with only a slight gain expected in October. And the slower inventory depletion suggests that firms are further along than expected in realigning stockpiles with demand, and that future improvement will need to stem from more significant improvements in underlying demand (see James Hamilton for a more positive interpretation).
Growth was further boosted by a jump in residential construction, but, as Calculated Risk points out, this sector's future contributions are likely to remain under pressure from high home and rental vacancy rate. Moreover, the impact of fiscal stimulus will fade as we move through next year, and there appears to be little political will to offer up additional stimulus.
Finally, note that net exports subtracted 0.53 percentage points of growth as import growth exceeded import growth. A balanced, sustainable recovery requires, in my opinion, that net exports contribute to growth. This showing reminds us of the ongoing dependence of US consumption on overseas production - stimulating consumption spending flows in part right out of the economy via imports. Recall also Federal Reserve Chairman Ben Bernanke's recent warning:
Another set of lessons that Asian economies took from the crisis of the 1990s may be more problematic. Because strong export markets helped Asia recover from that crisis, and because many countries in the region were badly hurt by sharp reversals in capital flows, the crisis strengthened Asia's commitment to export-led growth, backed up with large current account surpluses and mounting foreign exchange reserves….To achieve more balanced and durable economic growth and to reduce the risks of financial instability, we must avoid ever-increasing and unsustainable imbalances in trade and capital flows. External imbalances have already narrowed substantially as a consequence of the crisis...As the global economy recovers and trade volumes rebound, however, global imbalances may reassert themselves. As national leaders have emphasized in recent meetings of the G-20, policymakers around the world must guard against such an outcome.
Couple this with a Wall Street Journal story earlier this week:
For more than a year, China has kept the yuan largely unchanged against the dollar. So, like the dollar, the yuan has been falling steadily against the currencies of China's neighbors, including the Malaysian ringgit, the Indonesian rupiah and the South Korean won. That makes goods produced in those countries more expensive compared with China's."If you have one large economy in Asia lock itself against the U.S. dollar, everyone feels pressure," says Frederic Neumann, Asia economist for HSBC in Hong Kong. "Even 5% in this context feels painful."The countries that compete with China are at a critical juncture. To stem the rise of their currencies against the yuan (and the dollar), central banks around Asia have in recent months been purchasing gobs of greenbacks and building their foreign reserves. And now those reserves are back up to precrisis levels.At the same time, Asian economies are under pressure eventually to allow their currencies to rise and reduce their emphasis on exports to fuel growth. Some economists and international policy makers fear continued intervention in currency markets would reflect an unwillingness to break old habits of export growth driven by policies that kept currencies undervalued. Intervention can also raise the risks of domestic inflation.
Note also that the Europeans are growing frustrated with recent currency movements. From Market News International (no link):
European central bankers, worried that the soaring euro could squelch a nascent economic recovery, are increasingly pressuring U.S. authorities to put some bite into their bark(ing) about a strong dollar, well-placed monetary sources told Market News International.European monetary officials need the active support of U.S. and Chinese authorities to help restrain the euro and stem the greenback's slide, these sources said. Some noted that with the financial system awash in cash, it would be hard to mount an effective intervention in global currency markets.
The international political dynamics on this issue bear careful attention; it is not clear that the US and Europe will be able to tolerate Chinese currency policy indefinitely. But do they have a choice?
Add in another concern - the jobless (or perhaps job-loss) recovery. The underlying rate of economic growth (firms look through the Clunkers boost) remains well below rates sufficient to generate job growth. Indeed, as David Altig notes, the jobless recovery is almost certainly upon us once again, and if anything will prod the Administration to initiate a second stimulus package, it will be the prospect of sustained double-digit unemployment - an outcome that will only be aggravated if Chinese policy is to take advantage of the recession to consolidate more productive capacity behind its borders. Perhaps then we develop a new dependency, with Chinese saving redirected to US consumers via the US government rather than the housing market.
All of which boils down to a simply question: Can the US and global economies rebalance to a sustained, healthy pattern of growth without the cooperation of Chinese policymakers? In other words, can a Dollar depreciation against the Euro alone sustain a rebalancing? I think not, which implies that global economic stability is being supported on a very vulnerable base at the moment.
How will the Fed view these numbers? They will be relieved, but have much of the same skepticism regarding the sustainability of these numbers. Policymakers know the economy is being push along by a wave of federal stimulus, and are uncertain of how much momentum would be left in that absence of that stimulus. At the same time, however, the solid GDP showing will support already heightened worries that while interest rates need to be sustained at very low levels, officials may be late to the game when it comes to reversing the expansion of the balance sheet. Note St. Louis Federal Reserve President James Bullard:
“It is a little disappointing that private-sector economists are thinking so much about when we are going to move our fed funds rate up,” he said. “We are at zero. We are going to be there awhile. The focus should be more on” the Fed’s asset purchase program.
Given high unemployment and ongoing disinflation, there will be no rush to raise rates. What will comes first is the contraction in the balance sheet - and positive GDP numbers will push the discussion further in that direction.
Bottom Line: The GDP report is confirmation that the recession has come to an end. But I am not ready to breath easy - too many potentially unsustainable factors drove the boost, and too much remains dependent on federal stimulus. Until the economy can stand on its own, it remains vulnerable to unsustainable, unbalanced patterns of growth. And the negative contribution of trade to growth, especially coupled with growing tension over currency movements, is a warning sign that trade and capital flows are at risk of falling back into old and unehlpful patterns.