Ian McCafferty, the CBI's Chief Economic Adviser, has just returned from the USA, and has prepared the following briefing paper for CBI members. MIA is a member of the CBI on behalf of our members.
As the dust starts to settle, following the financial market turmoil in August, it is a good moment to take stock of the health and outlook for the US economy. Ian McCafferty, the CBI’s Chief Economic Adviser, spent last week on Wall Street and in Washington DC, taking the temperature and discussing both short and medium term prospects for the economy. While US economic growth remains constrained by the legacies of the financial crisis and the recent recession, and will be so for a considerable period, it seems the crisis of confidence, that occurred in August, about the immediate economic outlook has been something of an over-reaction. The likelihood of the economy tipping back into recession this winter is relatively low.
The fundamental differences of philosophy dividing the Democrats and Republicans in Congress, that led to the chaos over the Federal debt ceiling, will prevent any substantial progress on fiscal reform until after the 2012 Presidential elections. In the interim, there are a number of other fiscal hurdles, which if badly handled could lead to unwelcome fiscal tightening next year while the economy is still fragile. Most observers, though, are convinced that the most critical issues will be eventually resolved without significant damage to the economy.
Over the first half of the year, growth in the US economy has been disappointingly lacklustre, highlighted by the revisions to the GDP data that suggested that quarterly growth had been only 0.4% in the first quarter and 0.9% in the second. At this glacial pace, not only has unemployment started rising again (going over 9% by the summer, and thus causing serious political problems for the Administration), but many believe that the economy is close to “stall speed”, with a risk of tipping into recession in the immediate future.
It is certainly true that growth, this close to zero, leaves the economy vulnerable to recession: it would require only one damaging shock to tip it into negative territory - but there is no reason, in theory, why very slow growth inevitably ends in recession.
An economy is not actually analogous to an aeroplane, which literally falls out of the sky if its speed is too slow! What’s more, there are serious doubts about the accuracy of the current estimates of GDP growth, which are inconsistent with other, more reliable, data for the period. In the fullness of time and more data revisions, it may well turn out that the economy did not slow, in the first half year, as much as the GDP estimates suggest.
Many commentators believe he first half slowdown - however marked it was - can be well explained by a series of transitory factors.
The rise last winter in energy ad commodity prices that squeezed consumer spending power, the disruption to exports and supply chains from the Japanese tsunami, and the destocking that has accompanied the slowdown in growth in China all ate into the short term pace of activity. But these factors are already fading in importance, and will act as less of a drag over the second half. In addition, the sharp fall in consumer confidence which followed the US debt downgrade is beginning to reverse, supporting the view that there may well be some modest bounce back in activity. On what is known, from the monthly indicators already, the third quarter looks as if it will see GDP growth of some 2% at an annualised rate, with a similar rate anticipated for Q4. Even with this bounce-back, forecasters have been required to lower their annual predictions, with annual GDP growth now expected to be around 1½% in 2011 and 2-2¼% in 2012.
The main risk to this outlook is external to the US. Domestically, with both inventories and business investment still at low levels, the internal imbalances that could trigger a sharp cyclical drop in demand are not present. As such, even if consumer confidence were to remain moribund, it would be difficult to engineer anything more than a slight and short-lived fall in output. As a result, the most critical risk to the US economy is the upheaval in the Eurozone.
While US trade with Europe is small relative to the size of the economy, the US faces two key vulnerabilities. First, a deeper financial crisis in Europe would cause further turmoil on global stock markets, with major implications for both confidence and consumer wealth. Second, the US financial system is also exposed. Direct exposure of the US banking system to European peripheral countries is limited, but many of the CDS contracts that hedge the risk of downgrade or default in these countries probably ultimately originate from US banks. In addition, the exposure of US Money Market Funds (a major retail savings vehicle) to European banks represents about half of their total assets, and holding are concentrated around 15 European banks. Further sovereign or banking distress in Europe would thus put the US MMF sector under severe strain.
But while 2% growth through 2012 is better than recession, it has worrying implications. First, it is insufficient to bring down significantly the rate of unemployment, currently languishing at over 9%. This generates political uncertainty for, whilst it is less than a cast-iron predictive rule, no President has been re-elected in the last sixty years with unemployment above 7.2%. As a result, politics in the run-up to the elections are becoming a blame game, with both sides trying to pin the responsibility for policy failure on the other. In such circumstances, deal-making becomes more difficult and supportive policy action less dependable.
For many Americans, 2% also feels like failure, given how lacklustre it is by historical standards. In past recoveries, the US would have been growing by well over 3% by this stage, so the current string of data leads to a persistent sense of disappointment. As such, even a return to 2% into 2012 may not lift, for some time, the despondency that has descended on both businesses and consumers.
But this disappointment fails to take account of a couple of factors which are currently limiting how well the economy can perform, and ,under these circumstances, 2% or so is about as good as one can realistically expect, so such disappointment is unhelpful.
First, the US remains hobbled by legacies from the crisis and recession – the largest of these being the parlous state of the housing sector. This has been a traditional source of recovery for the US economy, but the sizeable excess of supply, that is a legacy of the boom, will take at least another year or two to work off, while mortgage lending conditions remain tight. This prevents some who would like either to take out a new mortgage or to refinance (and thus reduce the squeeze on their household outlays) from doing so. While the direct contribution to GDP from housing construction has already declined sharply, the wider implications of a moribund market – on jobs and consumer spending on housing-related durables - remain a critical source of drag.
Second, it looks as if there has been some structural change to the underlying potential rate of growth, which has fallen back from 3% in the 1990s, largely due to changes in the labour market. Net growth in the labour force has declined, for demographic reasons, and many believe that part of the unemployment problem is becoming structural, as those out of work lose vital skills. Both of these factors limit how fast the economy is able to grow.
How far the potential rate of growth has declined is a source of debate. Official estimates (used to calculate the budget trajectory) remain close to 2½%, but many in the private sector now believe it is not much more than 2%, at least for several years.
With unemployment such a hot political topic, all sides are trying to introduce new policy stimulus. The Fed is close to a new round of quantitative easing, but is likely to use other techniques (e.g. lengthening the maturity profile of its existing holdings) before allocating a new tranche of cash for additional asset purchases. On the fiscal side, the President has proposed a new round of spending and tax proposals, only a fraction of which are likely to get through Congress. Congress itself is awaiting the outcome of the ‘Super Committee’, which was set up in the wake of the debacle over raising the debt ceiling, and charged with finding a way to cut $1.5 trillion from the federal debt over the next decade.
If the Super Committee does not come up with those cuts, an automatic trigger will kick in, and $1.2 trillion of federal spending will be sequestered – i.e. cut automatically - with both defence and non-defence discretionary spending affected. With all this under way, it is, at this stage, far from clear what the 2012 federal budget will look like, or what its impact on the economy will be.
Beyond the uncertainties of the next year, the biggest headache remains the long term outlook for the US federal fiscal deficit. Beyond 2020, as the Congressional Budget Office has pointed out, the retirement of the baby-boom generation and the increase in per-capita health spend make “the budget outlook daunting”. Spending on health care and social security is projected to rise from 10% to 16% of GDP in the next 25 years – note that, over the past 40 years, total Federal spending excluding debt interest has averaged 18%. If this is not addressed, the US could be running an almost permanent fiscal deficit of close to 5% of GDP over this period. Only after the 2012 election will we know if there is enough political consensus to begin to tackle this huge issue.
An expanded version of this note will be published as a CBI Economic Brief in the near future.