This is the ninth installment of the LEIPLINE. Our focus each quarter is generally on the four variables for which we collect data and the implications of those data for the Jacksonville MSA overall. However, with the unprecedented turmoil inherent in the economy during the fourth quarter of 2008, we will expand our analysis in this edition to discuss broader constituencies and forecasts for upcoming quarters both locally and nationally. We also tackle causes and solutions of the current crisis. Consequently, this will be the only article for this quarter.
The Macro Economy
Below are some statistics regarding the macro economy. To borrow from a Clint Eastwood spaghetti western, we will compare the state of the macro economy for 2006 (the Good), at the end of the second quarter of 2008 (the Bad), and the end of 2008 (the Ugly). We will do so using five major economic indicators: GDP, inflation, unemployment, interest rates, and the balance on trade.
1. GDP Growth
Economists generally recommend 2.5-3.0% real GDP growth as optimal. Two consecutive quarters of negative growth is a rule of thumb for recession. In the current economy, the NBER says the recession began in December 2007 despite the first and second quarters of 2008 revealing positive growth. The third quarter was down 0.5% and the fourth 3.8% (the latter being preliminary and likely to settle even lower). The last time that data regarding real GDP growth were down in consecutive quarters was in the 1990-91 period despite the perception and designation of a recession in 2001.
The biggest component in GDP is personal consumption expenditures (PCE). PCE was growing at a 3.25% rate in 2006, at only a 1% rate in the first half of 2008, but due to both quarters being negative, at a -3.65% rate in the last 2 quarters of 2008. This has happened only 3 times since WWII, and only in 1980 was the two quarter drop bigger. It is important to note that none of the other major categories (investment, government spending, or net exports) has fallen, YET.
The 2006 value of 3.4 percent was relatively high for the 2000s, but 5.6% is the highest the CPI has been since 1982. Negative inflation is called deflation and there are only two causes: a really strong economy or a really weak one. Guess which one is the cause today! The decline in the price level during the latter half of 2008 was driven by declining oil prices, but by the end of the year the declines were pervasive with virtually all categories of the CPI revealing negative changes in both quarters.
The current unemployment rate is higher than any has been since 1986, but despite the realization that the workforce was much smaller then, a significant portion of the baby boom generation was still just entering the labor force, making the natural rate or presumed full employment rate higher in 1986 then now. Thus, 7.2% in December 2008 (7.4% in January 2009) of the work force unemployed is actually worse than the same magnitude in the 1980s. As the workforce has expanded, the numbers of two earner families has dramatically increased, but diminished population growth has reduced the full employment percentage.
4. Interest rates (the Prime Rate)
You might expect that these numbers go from ugly to bad to good, but the reason for the drop is that the banks are getting much tighter regarding who they will lend to and there is greatly diminished demand for loanable funds so bank spreads are rising but on much smaller loan portfolios. The loan rates are also so low that the banks are holding their money, not being willing to engage in intermediate or long term loans at such low nominal rates.
5. Balance on Trade
This may seem like good news like above, and it does reflect rising exports relative to imports which is good for GDP growth, but it is occurring because imports are falling more than exports, with both down. The trade sector was keeping the economy afloat through June 2008, but it is faltering too.
What Does It All Mean?
The U.S. economy is clearly in a recessionary spiral that can only be compared to the Great Depression for depth and likelihood of length. While deposit insurance has thus far limited bank runs, the financial markets have lost close to 50% of their value and the financial crisis of October 2008 has turned into a real market sector crisis since. Also troublesome is even worse signs in other parts of the world that bought faulty U.S. debt instruments and consequently have suffered the same difficulties in their financial and real sectors. Perceived financial wealth has been irrevocably lost and the spending of this lost wealth has gone with it. While the shrinkage of real GDP has only been about $510 billion in the last two quarters, the potential purchasing power for future quarters has fallen much more. This, therefore, limits opportunities and procedures to alleviate the weakness and return the U.S. and world economies to prosperity.
This Mess and the Great Depression
The Obama administration clearly proposes to fix the economy with major expansions in government spending to replace the declines in consumer spending. This path follows the same policy prescription used by President Roosevelt (FDR) in the 1930s, which depending on who you believe either assisted the recovery or did not. With the current global weakness, the Great Depression era has gained greater relevance and the solutions for the current crisis are assessed relative to that time period below.
There are now four generally accepted (by at least some economists) possibilities about what caused the recovery from depression. The first is the one that is probably accepted by more than the others, that the Second World War was the only reason that the world recovered some thirteen years after the stock market crash in 1929. The implication of this theory is that such a dramatic crash in the economy could only be eliminated by an equally massive event like the stimulus of military expansion. This is a truly pessimistic perspective if the world is headed to depression in 2009 because of its ramifications for the solution.
A second theory implies that the depression was caused by faulty monetary policy after the stock market crash (causing the money supply to fall by one-third by 1933), and so the solution was expansionary monetary policy that eventually caused the economy to return closer to trend. However, declining money velocity mitigated the expansionary influence of the growth of the money supply, and so the monetary policy took a long time to generate any positive value, if in fact it did.
The third perceived cause of the Great Depression is what the Obama administration clearly believes to be the cause for the current crisis as well: that the depression was caused by a decline in consumer spending due to the stock market crash and accompanying declines in wealth, generating job losses and a multiplier effect that eventually caused a 25% unemployment rate and over twelve years of diminished growth. The logic employed by both FDR (based on John Maynard Keynes) and the Obama administration is that if the cause was too little spending, then the solution is to replace diminished consumer spending with government spending. However, as was the case with FDR, and can already be seen with Obama, that government spending can only be accomplished for so long without raising taxes. There is evidence to suggest that the recovery during the depression was hindered by the tax hikes passed by Herbert Hoover before he left office and the additional tax increases that took effect in 1937. After passing the newest stimulus bill last week, earlier this week President Obama discussed his policy initiative to reinstitute “pay as you go rules” and establish fiscal responsibility in government (an oxymoron if ever we heard one). What this means is more taxes to pay for more spending, or cuts in government spending in one or more areas to permit more spending on new programs. Either one of thee propositions means contractionary fiscal policy effects that would stifle recovery just like it did in 1937.
The fourth depression solution is associated with a fall 2007 article by Frank Steindl (Independent Review, v. XII, n. 2). Steindl points to the automatic stabilizers inherent in the macro economy as what ultimately, overrode the Keynesian make-work policy of the FDR administration, the tax increases in 1937, the weak monetary policy of the young Federal Reserve, and the panics that marked the 1929-33 years. As the graph below implies, industrial production recovered dramatically from 1933 until 1942, not because of the New Deal but in spite of it. It occurred then, and it is already occurring now, that weak economic conditions that generate labor reductions produce more efficient management and workers, increasing labor productivity. This, in turn, lowers the costs of production and makes the economy more efficient so that prices can remain low or fall. This automatic effect helped the U.S. and world economies to begin recovering in advance of WWII according to Steindl.
Our perspective on the current crisis implies that the ground work for the crisis actually began with the Community Reinvestment Act of 1977 that motivated lenders to provide loans to customers with lesser credit ratings and ratios, as a means to reduce perceived discrimination in lending practices. This backdrop provided the climate to promote sub-primes, interest-only, and other types of non-traditional mortgage instruments. Next came the 1999 Financial Services Modernization Act that repealed the need for separation of commercial and investment banks under the 1934 Glass-Steagall Act. This did two things, it brought commercial banks into investment banking (an area where the commercial banks had no experience and little expertise), and it enhanced competition within investment banking that promoted the search for new instruments to sell to willing customers.
However, the true impetus of the current crisis, or more correctly, the occurrence that caused the crisis to occur now, was the escalation of oil and gasoline prices that began on January 31st 2007 and only subsided beginning on July 13th, 2008. The three-fold increase in oil prices not only caused costs of production to rise, but it motivated investment dollars to flee financial markets for commodity markets. The shortage of financial capital raised interest rates which caused the escalation of costs for borrowers through the sub-primes and other types of hybrid mortgages, and caused them to face untenable costs to maintain their properties. As the defaults began, it placed downward pressure on housing prices, reduced the incentives for investment in real estate, causing the housing market to collapse. This, in turn, caused the collapse in the mortgage-backed security and swaps markets, not just here in the U.S., but around the world.
How Do We Fix It?
We espouse the Steindl solution, both because it will happen anyway, and because it will lead to far smaller distortions and delays than the Obama/FDR solution. In the modern world, this approach has other allies that did not exist to a sufficient extend in the 1930s too called automatic stabilizers.
The demand side policy already in action in Washington will inject money into the economy and create some temporary jobs. They may also assist us in improving our woeful infrastructure and enhance energy efficiency. However, as mentioned above, the increased spending will necessarily beget either additional taxes, reduced alternative spending or likely both. These effects will detract from the recovery and lengthen the time that it will take (just like it did in the 1930s). This approach is also highly inflationary, which will reduce the value of the dollar initially, then mandate that the FED remove the excess liquidity which will also be contractionary.
Worse than both of these effects presently, is that all of these bailouts and stimulus packages seem never-ending and logically; banks, insurance companies, investment banks, and corporations in virtually all industries are either plotting, or receiving a piece of the handout pie. Those still in the plotting stage are holding off on actions relative to expansion and employment until they get theirs, and those that have received theirs are trying to figure out what to do with it, and whether they can get more. The policy of handouts creates stagnation, which is clearly lengthening the recovery time.
Whether any of the stimuli were necessary will never be known, but it is time to cease and desist so the corporations and small businesses throughout the economy can get back to producing output, providing services, and employing workers to get the economy going again. The automatic stabilizers such as tax credits and incentives, trade markets, unemployment insurance, welfare, food stamps, Medicaid, Social Security and labor productivity will solve the recession much faster without government intervention than they will with the wasteful, inflationary, ineffectual policies coming out of Washington today.
The Local Data
Since many of the data change for at least one month after we first report them, we have decided to wait until at least the middle of the following quarter to report each quarter's implications. Since the local CPI is the most significant variable that we analyze we will start with it.
The 2008.4 Jacksonville CPI
The change in the local CPI during the fourth quarter of 2008 revealed deflation (declining price levels), reinforcing the negative value for inflation in September. For the year that inflation rate for the Jacksonville MSA was actually -0.6%. Such outcomes are rare and can either signify a very strong economy or a very weak one. There is no disputing that the events of the last four months reflect the latter. The local numbers were once again driven by fuel prices and housing prices, but other consumer durables contributed to the declining prices, particularly new cars, and traditional Christmas fare. As discussed above, the expansion of the crisis beyond the financial sector has weakened consumer confidence (although there was a small rebound in January) and consumer expenditures, which has reduced prices due to lagging demand (the CPI rose 0.39% in January).
The outlook for the first quarter of 2009 relative to inflation might be more of the same. However, the passage of the stimulus package may signal expectations of greater spending that may spur price increases. It is interesting that fuel surcharges and higher commodity prices resulting from fuel fees have not diminished with oil prices. Gasoline prices inexplicable continue to rise as oil prices fall, yet another signal of the perversity of the current marketplace. Thus far the bailout programs are not stimulating lending which will continue to put a damper on inflationary pressures, but will also not help stimulate economic growth. We perceive that ultimately, prices will rise moderately in the first quarter, but without sizable impetus due to falling consumer demand and employment layoffs.
Unemployment rates in Jacksonville during 2008.4 exceeded the national rate each of the three months, continuing the pattern from the third quarter. Specifically, the unemployment rate is now 7.43 percent in the Jacksonville MSA, higher than any time in the last 7 years, and higher than the national average of 7.2% by the largest amount since we began collection data in December 2001. LEIP only seasonally adjusts the unemployment rate (we do not calculate it), but doing so provides valuable short term insight into the changes from month to month. For example, the unadjusted unemployment rate jumped moderately from 6.4% in September to 6.6% in October, but after seasonal adjustment the increase was actually almost four tenths due to the normal seasonality in Christmas season employment. During the fourth quarter the civilian labor force in Jacksonville fell nearly twelve thousand workers, but the number employed fell by over eighteen thousand. The outlook for the first quarter is not positive with all of the layoffs and weakness in the business sector. However, with increased business at the Port due to TraPac, a relatively small manufacturing sector locally that may imply fewer layoffs than elsewhere, and any positive employment that derives from the stimulus bill, the decline in employment may not be as severe in Jacksonville as it may be in other communities.
Leading Indicator (LEI)
The LEIP leading indicator was up the last two months of 2008, but the magnitude simply reversed the big drop in October). Worse, the preliminary January value was down nearly one full point, reducing the index to 2002 levels, and for the first time, below national equivalents. Consumer confidence in Florida rebounded from its December low in January, but only slightly. Last quarter we announced that initial claims for unemployment insurance exceeded 7,500 in October in the Jacksonville MSA, but in January they exceeded 11,000! Building permits are still way off from historical norms, meaning less economic activity and state tax revenue for the foreseeable future. Local headquarter stocks continued to hold their own in the third quarter (although October was horrendous), but the local presence stocks have plummeted as financial firms have lost considerable value. While the November and December numbers were heartening, it is hard to anticipate that anything but the money supply growth is going to drive the index higher in the near future, so the outlook for the middle of 2009 is likely not as good as we originally hoped.
Stock Price Index
The local stock index was dismal in the fourth quarter of 2008, following the national demise. The local presence stocks fell to over 3,600 below the DOW, while the local headquarters stocks are now 400 below the DOW. Last quarter we implied that local stocks seem to have been hit harder than the DOW companies due to the substantial presence of financial companies in Jacksonville, but the fourth quarter numbers reveal that the relative weakness is spreading to all types of local firms (except Walmart). There does not seem to be much good news for stocks either locally or nationally.
The Bottom Line, Locally
Overall, 2008.4 was the fourth consecutive weak quarter for Jacksonville and the nation in regards to the data LEIP collects or has access to in a consistent format. Retail sales slowed some more, particularly in December, unemployment rose, and inflation fell, but due to weakness in the economy not strength. The LEI remained virtually the same. The outlook for Jacksonville is not strong for the early part of 2009. As we emphasized above, if the fiscal government interference in financial and real markets ceases soon, and corporate leaders can then plan for recovery and the best strategies to grow their businesses, then the recovery will begin soon thereafter. However, if government involvement continues, and worse yet, escalates, then the necessary contractionary effects, perhaps on the military, and other programs that benefit Jacksonville, will mean that the weakness will continue, and likely persist for much longer than the few months or less that we would prefer.