Economist's Corner: Sifting through the tea leaves
By Carl Steidtmann, chief economist and director, Consumer Business, Deloitte Research
After a year of housing market decline and six months of financial market turmoil, the U.S. economy will start off the New Year in a recession. I am somewhat loathe to use the word recession because it conjures up all kinds of very negative images from the 2001-02 experience, and I think this downturn will be very different from an economy-wide perspective.
What accounts for this difference are the driving factors behind the two business cycles. The 2001-02 downturn was technology related. It started with the bursting of financial bubble in tech stocks. What followed closely after was a round of tech-related bankruptcy that was almost entirely income statement related. As it turned out sock puppets were not a reliable business model. The entire downturn was made worse by the shifting of technology investment due to remediation of the Y2K bug.
The current downturn will be consumer-focused and is being driven by a bursting of a financial bubble in the mortgage debt market. The loss of credit creation for mortgages in turn is leading to a decline in home prices and the loss of mortgage refinancing money. What will follow will be significant financial service business distress and bankruptcy that is almost entirely on the balance sheet.
Recession signals
The signs of a recession first show up in financial markets and are all around us. First and foremost we have seen large and dramatic increases in risk spreads, the difference between the interest rate on risk free assets like Treasury bills and the rate on asset-backed commercial paper. The spread between CP and T-Bill rates should be around 15 to 30 basis points. Recently, they have been as high as 225 basis points.
Secondly, with higher risk premiums, there has been a corresponding sharp fall in credit creation. Business credit in the three months ending in December fell at its fastest pace since 1973. The contraction in credit creation and the continued tightening of credit is a second leading indicator of a coming recession. Credit creation is what ultimately drives growth and without it, growth has to be financed by internal means or it does not happen.
The recently announced Treasury bailout plan for sub-prime lenders is only going to add to this problem. By freezing rates and reducing the cash flow to the banks from existing borrowers, this plan ties up bank capital in underperforming credit. At the same time, it will increase the cost and terms of borrowing for future home buyers. Reduced future demand for housing will put additional downward pressure on housing prices. Falling home prices more than rising home payments is what is driving the soaring rate of mortgage default and the Treasury plan does nothing to help with that problem.
What will make this recession so difficult from a consumer business perspective is the coming drop in home prices. The decline in home prices is just getting started. Given the build up in unsold inventories of homes, with the rise in mortgage foreclosures that will occur even with the Treasury bailout plan adding to that total, home prices are likely to fall 10 to 20 percent over the next couple of years. Falling home prices will reduce household net worth by $2 to $4 trillion, eliminating home equity withdrawal as a source of future consumer spending.
All of which leads us to the fourth leading recession indicator, a decline in corporate profitability. Market economies are all about profit growth. When profits rise, businesses hire more workers, take more risks and make more investments. When profits decline, businesses respond by cutting costs, reducing head count, raising cash and limiting investment, all of which has a negative impact on the economy. U.S. Treasury receipts from profits have declined in 5 of the past 6 months. For the last three months through October, receipts from profits fell 30 percent from a year ago.
Not all is lost. What will keep this recession relatively mild will be solid growth overseas, giving a boost to U.S. exports. U.S. export growth has risen 15 percent from a year ago. With the dollar’s slide on foreign exchange markets, U.S. exports will continue to take market share. Also adding to the mild nature of any recession is the lean nature of inventories. Traditionally, recessions have been deepened by the swing in inventories. Years of investment in supply chain technologies has removed this threat to the economy.
What will determine the longevity of the recession will be the public policy response to it. In the early 1990s, both the United States and Japan faced a similar bank balance sheet kind of recession. The United States responded vigorously to the problems in the S&L industry, forcing banks to recognize their losses. Weak banks were merged or closed. Non-performing assets were sold off as the industry was rationalized as quickly as possible. It was not a pretty process and it cost the U.S. Treasury some $350 billion. Japan took a different course. It allowed the ailing banks to remain in business. Losses were not recognized, zombie banks that tied up capital with little hope of return much less recovery were allowed to stay in business. The Japanese government sought to spend its way out of the recession with giant public works projects and dramatic cuts in interest rates. Japan suffered a decade of sluggish growth and deflation, the United States got a decade of solid growth and low inflation.
So far, the public policy response in the United States has not been encouraging. The Fed has lost a lot of credibility in caving so quickly to the equity markets following the Jim Cramer scream. In doing so it has created even greater future morale hazard, replacing the "Greenspan Put" with a "Bernanke Put." The U.S. Treasury has been even more disappointing. The attempt to create a Super fund to buy up some of the banking system debt has gone nowhere and by Secretary Paulson’s own admission is only designed to give the banks some time in marking their value-depressed assets to market.
The more recent mortgage solution which was given the Orwellian title of the "Hope Now Alliance" has no chance of giving much hope to anyone. Freezing rates to existing mortgage holders will only force the cost of future mortgages higher, further reducing the future demand for housing. At best this effort, like the Treasury’s super-SIV idea that puts off a more rapid adjustment to the problem of too many home owners having too much debt. It gives the appearance of doing something but does nothing to address the underlying problem. If this is successful, all sorts of models both mental and mathematical will have to be recalculated to take into account the risk of increased government intervention and reduced banking transparency.
What to do?
Businesses need to plan for the worst while hoping for the best. Cash will remain king. Banks will be no help in raising future capital. Consumers will become ever more price driven as once abundant home refinance money dries up. Keeping inventories lean, expansion plans modest and labor costs in check will provide a solid financial base from which all businesses will be able to weather the coming storm.
About Carl Steidtmann
Carl Steidtmann is Deloitte Research's chief economist and a director of Consumer Business Research. In 2003 Consulting Magazine selected Dr. Steidtmann as one of the 25 most influential consultants for his work in consumer spending forecasting. He earned his Ph.D., master's and bachelor's degrees from the University of Colorado. He is based in New York.
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