Is the US Economy Stuck in a 2% Growth Path?
The most imposing economic challenge facing the winner of the Presidential election is getting the US economy back on a faster growth path. The economy has been seemingly stuck in second gear since the end of the Great Recession: the average annualised growth rate of the economy has been just +2.2%. The lacklustre rate of growth is one reason why unemployment remains stubbornly high.
The relationship between economic growth and unemployment is often quoted within the context of so-called Okun’s Law. The law denotes a statistical relationship aimed to give policymakers a guide to how much output will be lost if unemployment rises above its so-called natural rate. The generally accepted rule-of-thumb was that for every 1 percentage point increase in the unemployment rate above its natural rate, real GDP would fall 2% relative to its long-term trend.
The natural rate of unemployment is that rate consistent with price stability. It is determined by secular and “real” economic forces, such as growth of labour supply and productivity growth. Attempts to reduce the actual unemployment rate via easier monetary policy below its natural rate will eventually lead to rising inflation, according to monetarists. The natural rate of unemployment can, however, also be affected by shocks. Some commentators believe that the financial crisis has raised the natural rate of unemployment, implying that the long-term sustainable growth path of the US economy has been reduced.
What Is the New Sustainable US Growth Rate?
The US economy grew at an average annual rate of +2.8% in the 5-year period prior to the Great Recession. The +2.2% average growth during the subsequent recovery period implies that US trend growth has been reduced by -0.6%. The International Monetary Fund (IMF) is more pessimistic in its assessment of potential output loss. Prior to the financial crisis, the IMF estimated that US potential GDP growth was 3%. It has now been downgraded to 2%. If the IMF’s pessimistic assessment is correct, then the challenges facing the US to generate enough growth to lower unemployment becomes much tougher.
The civilian unemployment rate averaged 5.2% in the 5-year period before the Great Recession. Since the recovery began in 2009 H2, the unemployment rate has averaged 9.1%. If the IMF’s estimate is correct, then the 1% reduction in potential GDP growth since the financial crisis has seemingly had a huge impact in producing elevated unemployment. The Fed is, however, less pessimistic than the IMF, believing that potential GDP growth is around +2.5% and the natural rate of unemployment is 5.2%-6.0%. This implies that a considerable amount of the current headline 7.9% unemployment rate is cyclical and the result of deficient aggregate demand. This explains why the Fed has decided to target elevated unemployment as the most important policy goal.
Housing’s Impact on US Trend Growth
The recovery in most measures of housing activity would indicate that it is no longer a drag to headline GDP growth. The US housing boom-bust cycle has had ramifications on US economic performance via a number of channels. Firstly, overbuilding of the US housing stock boosted the contribution of residential investment to headline GDP growth. The average contribution of this component to headline GDP growth between 2002 and its peak in 2005 was 0.4 percentage points. Headline GDP growth averaged 2.9% during this period. The housing construction boom would also have imparted a positive “multiplier” effect via housing-related consumer spending. The final two years of the prior expansion saw average GDP growth slip to 2.3%, but residential investment’s contribution to headline GDP growth became a significant headwind, averaging -0.9% percentage points. In other words, housing investment had an asymmetric impact on headline GDP growth after the peak had been reached in 2005 Q4.
The second channel through which the housing boom-bust cycle impacted growth dynamics was job creation. Between 2002 and 2005, non-farm payrolls rose on average only +85K per month. Housing-related gains averaged +21K per month over the same period. For the remainder of the previous economic expansion, monthly changes to non-farm payrolls averaged +132K, while average housing-related gains were -17K per month.
The final and most obvious channel through which the housing boom-bust cycle distorted overall economic growth dynamics was the build-up of household debt and the subsequent requirement to engage in deleveraging. The creation of a debt overhang is an important reason why potential GDP growth appears lower in the post-Great Recession era. How is the US faring in terms of deleveraging?
US Debt Cycle Revisited
The US economy is still experiencing the legacy of a so-called debt super-cycle. US private sector debt has grown faster than nominal GDP in almost every non-recessionary year over the past 60 years. Private non-financial sector debt rose from 53% of GDP in 1951 to peak at 180% in 2007. It still stands at an elevated 160% in 2012. Household debt peaked at 98% of GDP in 2007, but has since receded to 83% in 2012. Are we close to the end of household deleveraging?
There is no consensus about how to measure the optimal level of household debt. The convention has been to analyse aggregate debt as a % of GDP or disposable income. This approach assumes that GDP and disposable income growth are proxies for the ability to service debt. Both the asset side of the balance sheet and the level of interest rates are, however, not taken into consideration. These are important omissions: the Fed’s pursuit of quantitative easing has helped to reduce household debt service ratios. Meanwhile, mortgage debt as a % of the value of owner-occupied housing remains high at 60% compared to a pre-financial crisis average of 40%.
The task of forecasting the end of household deleveraging is complicated by the distribution of homeownership and mortgage debt. Approximately 33% of US homeowners have no mortgage debt. The aggregate data for household debt will, therefore, paint a particularly bleak predicament for mortgage holders. According to Zillow Inc, around 31% of US mortgages were under water in Q2.
The Pace of Future Deleveraging Will Be Crucial for Economic Growth
Deleveraging per se is not disastrous for economic growth. It is the pace at which it occurs that is critical. Erratic changes in the pace of deleveraging will produce similar changes in economic growth. From this standpoint, it is imperative that future US household deleveraging occurs at a steady rate so as not to impair the economy’s ability to grow.
The timing of the end of US household deleveraging will be determined by debt growth and income growth. If the level of outstanding household debt remains unchanged, but disposable income grows at, say, 5% per annum, then debt-to-income levels will return to past trend levels at the end of 2014. Extrapolating the historic trend growth rate could, however, prove to be a heroic assumption. Given that household owner-occupancy rates are unlikely to return to the levels seen at the peak of the last housing cycle, a return to the debt-to-income ratios seen in the 1990’s could be on the cards. Under this scenario, assuming zero growth in household debt and 5% annual disposable income growth, deleveraging would end not until the end of 2018. If debt levels contracted, then deleveraging could end sooner, but economic growth would probably suffer.
Financial Sector Deleveraging Probably Completed
One sector of the US economy where deleveraging has probably been completed is the financial sector. Both the commercial and investment banks have significantly reduced their leverage since 2007 via a reduction in both assets and debt. The Fed is committed to keeping the federal funds target until 2015. It implies that financial sector balance sheets should continue to improve.
Business Leverage at High Levels
One of the oddities of the recovery from the Great Recession is the impressive recovery in corporate profits, along with high levels of liquidity. These developments have had bullish implications for the stock market. The situation is somewhat different for unincorporated business (accounting for 31% of business sector GDP): finances in the sector are in less pristine shape than the corporate sector.
High levels of business debt need not be problematic if proceeds are used to finance business expansion. This has not, however, been the case: growth in the private non-residential capital stock has slowed dramatically in recent years. This helps to explain why capital spending and hiring have remained so sluggish, despite the impressive recovery in corporate profits.
Federal Government Needs to Eventually Start Deleveraging
The combined intervention of the federal government and the Fed helped to prevent the onset of another depression. The next challenge for the federal government is to adopt a more sustainable fiscal path. This task requires bold changes to entitlement programmes being instituted. Financial markets have yet to force the hand of politicians to make these decisions. If serious mechanisms to put the US back on to a sustainable fiscal path are not at least discussed by the time of the next mid-term elections in 2014, then markets may start to lose their patience. The days of cheap US sovereign funding costs could be numbered.
Summary and Conclusions
The US economy has been stuck in a +2% growth path since the end of the Great Recession. Some commentators conclude that the US potential growth rate has fallen, making it more difficult to reduce elevated unemployment. Under this scenario, the natural rate of unemployment has seemingly risen.
The IMF has reduced its estimate of US potential GDP growth by100 basis points to 2% since the end of the Great Recession. Meanwhile, the Fed is less pessimistic, believing that a significant component of the headline unemployment rate is, in fact, cyclical.
The housing boom-bust cycle affected US growth dynamics in an asymmetric manner, producing far stronger headwinds to growth after the bubble had been burst. The bubble encumbered the household and financial sectors with debt and a need to subsequently engage in deleveraging. This process is probably complete in the financial sector, but has not yet been completed by households.
Corporate debt levels are high, but liquidity and profits are also high. Balance sheets in the unincorporated business sector are less pristine than their corporate counterparts. This could explain why capital spending and hiring have been so sluggish.
The federal government leveraged its balance sheet to prevent another depression, placing fiscal policy on an unsustainable path. The next Administration and Congress will need to start at least discussing possible rectitude by the mid-term elections in 2014, before financial markets begin to lose their patience.
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