Kamis, 21 Maret 2013

Why is everyone so gloomy?

It's fashionable to lament the economy's very slow recovery, which by some measures—notably the number of new jobs created—is the weakest in modern times. Even the Fed has succumbed to the pessimism that pervades the bond and stock markets. Yesterday the FOMC members revised downwards (albeit only slightly) their forecasts for growth. Real GDP this year is now expected to grow 2.3 – 2.8%, vs. a Dec. 2012 forecast of 2.3 – 3.0%; real GDP next year is projected to grow 2.9 – 3.4%, vs. an earlier forecast of 3.0 – 3.5%; and real GDP in 2015 is expected to grow 2.9 – 3.7%, vs. an earlier forecast of 3.0 – 3.7%. Over the longer run, the FOMC continues to expect growth of only 2.3 – 2.5%. I've used the average of those forecasts to generate the chart below.

If the FOMC members are right, then the economy is never going to return to its previous full-employment potential. For the 50 years leading up to the last recession, the U.S. economy grew at an annualized rate of about 3% per year. You can see that in the green line on the above chart. The FOMC's forecast (orange line) says we'll never return to that growth path. If that's not a pessimistic outlook, I don't know what is.

This pessimism can be seen in the TIPS market as well. 5-yr real yields on TIPS are trading at -1.72% today. That means that the purchaser of these TIPS (and by the way, the Fed is not buying TIPS at all, so it is arguable whether the Fed is artificially depressing TIPS yields) knows up front that he is guaranteed to lose 1.72% of his purchasing power every year for the next 5 years. Presumably, it only makes sense to enter into this transaction if one is extremely worried that alternative investments will yield even worse results. Furthermore, there is a form of arbitrage between the real yield on TIPS and the real growth of the U.S. economy. If one thought that the economy were going to grow 4% a year, would it make any sense at all to buy TIPS with a real yield of -1.72%? No, because an economy growing 4% a year is almost certain to throw off real returns that are well in excess of zero: it would thus be much better to buy a basket of stocks than to buy TIPS. As the chart above suggests, today's negative yield on TIPS is consistent with a market that expects real growth in the economy to be close to zero for the next few years. Note that when the economy was posting 4-5% real growth in the late 1990s, TIPS yields were 3-4%. If the Fed were absolutely confident that the economy would grow 2-3% over the next several years, would they be comfortable keeping short-term rates at zero? No. Which means that even though they "expect" real growth to be modest, deep down inside the FOMC members are very worried that if they don't "do something" growth might be closer to zero than to their current projections.

There are other telltales of gloom as well. The PE ratio of the S&P 500 is currently just over 15. That is significantly below its average of 16.6 since 1960, especially when you consider that corporate profits as a % of GDP are very near their all-time high. The only explanation of these facts is that the market expects profits to decline significantly in coming years. 30-yr Treasury yields—which are difficult if not impossible for the Fed to influence directly—are trading at just over 3%, which is very near their lowest level on record. Who would buy a 30-yr T-bond at 3% if he or she didn't expect nominal GDP growth to be 3% or less? With long-term inflation expectations fairly stable at 2.5%, that means long bonds are priced to the expectation of a miserable 0.5% annual real growth for as far as the eye can see. 

For some reason, almost everyone—including the FOMC—seems to be assuming that the world changed dramatically in the year 2008, when the labor force participation rate (the percentage of the population that is either working or looking for work) suddenly started to decline, from 66% to today's 63.5% (see the second chart above). At the same time, growth in the labor force (those working or looking for work) flatlined. Call it the "new normal" if you will. But does this really have to be permanent? Demographics don't change like that overnight; perhaps the decline in the participation rate has more to do with a change in the incentives to work. 

As the chart above shows, there was a sharp increase in the number of people receiving food stamps that began in early 2009. The number had been relatively flat for the previous two decades, but in the past four years the number of food stamps recipients has jumped by 50%. Two factors probably explain explain this: 1) the severity of the economy's decline in the 2008-09 recession, and 2) a relaxation of eligibility standards which took effect in the early weeks of the Obama administration. Although the average benefit per household today is only $277, it is possible that this has reduced the incentive of many workers to seek and accept a new job. But it's not a very convincing argument. 

You've probably heard the stats: since Obama became president just over four years ago, there has been a net increase of only 1.4 million jobs, while the number of people receiving disability benefits has increased by 1.6 million. But as the chart above shows, the number of people receiving disability benefits has been growing at a fairly steady pace for the past 20 years: about 4% annualized per year (and I hasten to note that the number is up only 2.1% in the past year). Nothing unusual happened in this program that might explain the sharp decline in the labor force participation rate beginning in 2008. That's not to say we don't have a problem with the disability program, whose ranks have been increasing four times faster than the population for the past two decades, because we do. It's just that this has been an ongoing problem for a long time. 

The chart above shows that there was a huge increase in federal spending as a % of GDP that began in late 2008. As I noted in a post last October, over 75% of the $840 billion allocated to "stimulus" spending in the 2009 ARRA was essentially devoted to transfer payments: taking from one person and giving to another. Only 8%, or $65.5 billion, was spent on transportation and infrastructure projects. In the post-war era, we have never seen an increase in government spending of this magnitude. So much money was handed out in such a relatively short period that it could conceivably have caused perverse incentives (e.g., rewarding those who weren't working) that encouraged people to "drop out" of the labor force. But when you consider that the huge increase in government spending was accompanied by a huge increase in regulatory burdens (e.g., Dodd Frank, Obamacare) and a huge increase in expected future tax burdens (a direct result of the doubling of the federal debt/GDP ratio since 2007, from 37% then to over 75% today—see second chart above), then we probably have enough ingredients for this to be an important driver of the tepid jobs market.

In short, companies are holding back on their hiring plans, worried about regulatory burdens and big increases in mandated costs. And many individuals have probably decided that the rewards to working harder or returning to work are outweighed by the costs (e.g., higher taxes) to doing so. (I for one have decided I'd rather work for free on this blog than pay a 65% marginal tax rate on any new income I might generate from starting a small business.) This article has a nice summary of what Obamacare means for many colleges and many small businesses: sharply increased personnel costs, reductions in hours worked, layoffs, increased disincentives to work. One can only begin to imagine the depressing effect of the prospect of significant increases in future tax burdens that have resulted from the huge increase in our federal debt burden in recent years: after all, spending is taxation, even if it is deficit-financed. And then there is the strong likelihood that much of the increased federal spending in recent years has been a waste of our economy's scarce resources. We've taken over a trillion dollars a year for four years and essentially flushed them down the toilet, spent on things that do not increase the economy's productivity and that reward leisure or inactivity instead of work or entrepreneurial risk-taking.

The huge growth in the size, scope, and burden of government is thus the most likely explanation for why we are living through a disappointingly slow recovery. There is hope for the future, however, since federal spending as a % of GDP is already down significantly in the past two years, and the federal deficit has already declined significantly as well (in both nominal terms and relative to the size of the economy), thanks to very slow spending growth and the ongoing recovery, which has boosted tax revenues. But for significant progress towards a healthier economy we will likely need to see outright reductions in regulatory burdens and in the growth of spending, particularly entitlement spending.

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