Pop, Pop, Pop

DKW, October 22, 2009

This time these pops are caused by bubbles forcing open champagne bottles. The cause for the celebration is the end of the Great Recession as some are calling it. The consensus is that the recession ended in July or August and even the feds have quit shading their graphs for recession. If deemed so by the National Bureau of Economic Research several months from now, it will mark the end of an arduous economic cycle unmatched by most measures since the Great Depression.

How bad was it? Bad.

This 2007 recession has lasted more than twenty months, twice the length of the average post-war recession and months longer than the harsh recessions of 1973 and 1981, both 16 months. Real GDP growth was negative for four quarters in a row. That has never happened before in quarterly data dating back to 1947. Only two quarters in the last fifty-three years suffered as large a GDP loss as did the back-to-back quarters of Q4 2008 and Q1 2009, one was Q1 of 1958 and the other was Q2 in 1980. Personal consumption expenditures were negative in three out of four quarters, with the other one registering just 0.1 percent growth. That has never happened since 1947. Gross private domestic investment was negative for seven quarters in a row. That has happen only once since 1947, Q1 1979 to Q3 1980, leading into the double dip recessions of 1980 and 81. Gross private investment in residential structures was down fourteen quarters in a row, beginning in Q1 2006, a trend that may not be finished.

This is the first time that the economies of the U.S. and Japan were in recession at the same time. In fact, it was the first time since WWII that aggregate global economic growth turned negative.

Why was this recession so bad? There were two breakdowns, one on top of the other. The first one started in December 2007 and was an economic recession, begun by falling demand for housing construction. The second breakdown began in earnest in September 2008 and was a financial crisis, brought about by the deteriorating underlying asset collateral value (housing) of new unregulated financial tools and products (derivatives). The first breakdown led to the second. They became interdependent and fixing each is necessary for sound future long-term economic growth.

Volumes will be written on this great recession of 2007. A brief synopsis follows here. Debt was cheap and highly utilized across all sectors of the economy around the world. Low interest rates and other incentives led to a wave of debt-based asset accumulation (buying stuff on credit: homes, businesses, cars, vacations). A home buying spree ensued as did commercial debt-financed acquisitions. Housing developers and business financiers responded with enthusiasm. Lenders and their brokers, with the help of the federal government, did their part to make home ownership more accessible. Early on, housing supply could not keep up with demand and housing prices increased (housing bubble). In parallel, global economic gains swelled stock market values (financial bubble). The financial industry created new tools to extend and diversify the new debt loads, including home mortgage debt. These new tools — derivatives — were unregulated, off-exchange transactions between individual parties. Huge amounts of cash and capital (bonuses and investment) were being generated by the use of these derivatives.

Kicking off the recession was a decline in the single-family residential construction sector when the supply of new homes overtook the demand. When housing became over supplied, prices began to adjust (fall). Coupled with adjustable rates on hybrid mortgages (subprime and liar loans), mortgage defaults increased as home values became worth less than the debt owed ("underwater") and/or the homeowner's cash flow got squeezed by higher mortgage payments as the adjusted, higher mortgage rates took affect – a housing crisis.

Setting off the financial debacle was discovery of the magnitude of consequences that the dense daisy-chains of newly created financial products (derivatives trading), heavily dependent on the cash flow from the now defaulting underlying securitized assets (mortgage and other debt payments), entailed (house of cards). More importantly, issuers of debt default insurance (e.g., MBIA and AIG) were hugely under capitalized (not enough money to pay out claims). When debtors couldn't pay and insurers couldn't pay, lenders faced gargantuan losses – a financial crisis.

The crisis quickly spread across sectors and across geographies as financial markets are highly integrated worldwide. Global credit markets froze. Without liquidity (cash) to lubricate the gears of the economic machine, the global economy seized, compounding the on-going recession.

The severity of this recession affected employment in a commensurate manner. Wisconsin's unemployment rate doubled from a seasonally adjusted 4.5 percent in December of 2007, when the recession began, to 9.0 percent as of July 2009. (Wisconsin last exceeded this unemployment rate with a peak of 11.8 percent in January of 1983, after the recession of 1981-82.) Wisconsin's unemployment rate decreased as this is being written to 8.3 percent for September 2009.

Wisconsin lost 137,000 jobs during this downturn, about 5 percent of its job base since the recession began in December 2007, on a seasonally adjusted basis. All sectors suffered job losses with the exception of health care. The manufacturing sector lost 13 percent of its job base statewide during this recession, some 66,000 jobs on a seasonally adjusted basis. All of the upper Midwest major manufacturing states took a beating in this business cycle. Especially hard hit were Michigan, Indiana, and Ohio, due to the collapse of the auto industry. With large manufacturing job losses in Indiana, Wisconsin became the leader in the share of its workers employed in manufacturing. Construction, which was the first industry to be affected by the housing slump that began in Wisconsin in 2006, lost 16 percent of its jobs since December 2007, and almost 20 percent since its peak in February of 2006. Professional and Business Services also lost more jobs on a percentage basis, 8.9 percent, than the state all-industry average. Other sectors lost jobs as well, but were not impacted quite as severely as those above. Leisure and Hospitality, for example, lost 1.4 percent of its jobs. (Employment recovery always lags economic recovery. See previous entry on employment cycles.)

Cheers to Recovery

That is now history. The latest economic indicators are showing improving and even positive recordings. The leading economic indicators index has increased for five months in a row. Housing has turned, with existing and new home sales well off their lows. Industrial production has breached the 50 mark (signaling growth) and is broadening across sectors. Utilization capacity continues to increase, 70.5 percent in September. Consumer confidence is climbing. Real personal consumption expenditures are up four months in a row. September retail sales excluding auto sales from "cash for clunkers" increased 0.5 percent. Unemployment claims are coming down and job losses are less severe. Expectations for third quarter GDP, preliminary data out October 29, are in the positive 3 percent range.

Global economic growth is turning positive as well. China is registering positive economic growth as is Japan, Germany, and France. Even England is expected to post positive GDP numbers for the third quarter.

All good news. But before we get too carried away and start singing "Happy Days are Hear Again", we need to factor in some of the mood dampening items (party poopers). The boost from CARS ("cash for clunkers") is done and the home buying tax rebate incentive has all but run its course. Consumption growth is somewhat suspect due to the household wealth destruction brought about by the decline in value of housing and financial portfolio equity. Most economic indicators, while trending up, are a long way from prerecession peaks. Consumer confidence is at about 70, off the 90 marks of 2007. Housing sales are half prerecession levels and housing starts, at 590,000 units, are a quarter of peak levels. September domestic auto sales are running at a 6.7 million unit annual rate, half the 2007 levels. In addition, about 30 percent of reworked mortgages are not performing and bankruptcies continue to increase. There are a very large number of adjustable rate mortgages to be reset in the next two years. Commercial real estate is now suffering increased defaults. Employment is still down about 4 percent from peaks and job losses continue. Job recovery is expected to be subdued, not seeing gains until well into 2010. A large amount of toxic assets remain on the books.

Taken together, the economic situation may look as confusing as ever. But the major economic trends appear positive and hopefully will generate enough momentum to carry through. I expect growth from here on out, but not particularly robust, with some probable set backs. So instead of partaking of the bubbly, pardon me if I just have a beer.

Written by Dennis Winters, Chief Economist and OEA Administrator. October, 2009.

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