by Lance Roberts
Yesterday I was directed to read a piece by Brad Delong, Professor of Economics at Berkeley and a research associate at the National Bureau of Economic Research (NBER), entitled "The Greater Depression."
The entire piece is worth reading, however, here is the clincher:
"Meanwhile, in the US, the Federal Reserve under Janet Yellen is no longer wondering whether it is appropriate to stop purchasing long-term assets and raise interest rates until there is a significant upturn in employment. Instead, despite the absence of a significant increase in employment or a substantial increase in inflation, the Fed already is cutting its asset purchases and considering when, not whether, to raise interest rates.
A year and a half ago, those who expected a return by 2017 to the path of potential output – whatever that would be – estimated that the Great Recession would ultimately cost the North Atlantic economy about 80% of one year’s GDP, or $13 trillion, in lost production. If such a five-year recovery began now – a highly optimistic scenario – it would mean losses of about $20 trillion. If, as seems more likely, the economy performs over the next five years as it has for the last two, then takes another five years to recover, a massive $35 trillion worth of wealth would be lost.
When do we admit that it is time to call what is happening by its true name?"
Brad is absolutely correct. The chart below shows the current "gap" between real and potential GDP as estimated by the CBO.
The dashed "red" line is just an extrapolation of the current growth trend which corresponds very closely with Brad's assumptions of continued sluggish economic growth. However, I am going to suggest that even Brad's view may be a bit optimistic.
One of the major flaws in most analysis, including that of the CBO, is the lack of inclusion of normal business cycle recessions in the forecast. As shown above the CBO does not include in its projections any periods of negative economic growth for an entire 13-year span. As shown in the chart below, that the longest economic expansion on record was 119 months driven by a collision of massive debt expansion, falling interest rates and inflation, and a technological revolution. With interest rates and inflation at extremely low levels, consumers extremely levered and real employment and wage growth weak; it seems a bit naive to suggest that the current economic cycle could continue to "struggle along" for 159 months.
Therefore, if we make an assumption that a recession will likely occur between 2016-2017, it would equate to a period of economic expansion falling between 78 and 90 months. During a recession, where economic growth rates decline, the "gap" between real and potential GDP will widen. Such an event will extend the period for a "return to normalcy" far longer than currently expected.
Furthermore, to support Brad's point, the current "output gap" as a percentage of GDP still remains at levels normally associated with recessions as shown in the chart below.
While it has improved somewhat over the last five years, IF the economy was indeed improving as much as currently believed by the financial markets, the "gap" would be far smaller by now.
Real Employment Is The Real Problem
When it comes to economic growth, particularly in an economy that is almost 70% driven by consumption, employment is critical. Brad notes that the Federal Reserve is exiting its ongoing monetary interventions without evidence of a significant increase in employment. While jobless claims have indeed fallen, this has been a function of "labor hoarding" rather than increases in actual "full-time" employment.
"As I have discussed previously, much of the effect of the decline in jobless claims is not due to substantial increases in actual employment but rather to the effect of"labor hoarding." Since "initial" jobless claims are a function of "newly" terminated individuals filing for benefits it is logical that when companies cease terminations, and"hoard" their existing labor force, claims will fall."
The issue is that the only type of employment that really matters with respect to long-term economic prosperity is "full-time" employment. It is only full-time employment ultimately leads to higher rates of household formation. Unfortunately, since the financial crisis, full-time employment has been primarily a function of population growth rather than a strengthening economy. This is why the labor force participation rate remains near its lows.
Yet, the employment situation may actually be far worse than it looks based on a recent study from the Brookings Institute.
"Perhaps more striking, our research showed that the decline in new firm formation rates had occurred in every U.S. state and nearly every metropolitan area, in each broad industry group, and in all firm size classes – or the same patterns we have just reported for the share of mature firms. Figure 3 plots annual rates of firm entry and exit between 1978 and 2011.
As it shows, the rate of new firm formations fell significantly during this period—occurring because the number of new firms being formed each year (numerator) didn’t keep pace with the growth in the stock of total firms in the economy (denominator). The same was not true of firm exits, which did keep pace with the growth in total firms—allowing the firm failure rate to hold mostly steady before rising in the second half of the last decade."
Why is this important? Recent analysis at ZeroHedge provides an interesting clue:
"Starting in 2009, the Birth/Death adjustment alone has added over 3.5 million jobs..."
In other words, what the Brookings Institute found was that there were far more "deaths" than"births" of new businesses since 2009 which would be a net subtraction to the monthly employment reports. However, the BLS has been using the same methodology to adjust employment data higher assuming that the economy of today is the same as it has been in the past. This is clearly not the case which should be evident by the roughly 94 million individuals sitting outside of the labor force currently.
The inherent problems of a large and available labor pool is that it leads to suppressed wage growth which inherently translates into weaker consumption. My friend Doug Short recently showed this phenomenon in his analysis of median household incomes.
"In the chart above, the seasonally adjusted trough in August was 6.8% below the level in the month the recovery started. Following that low, there has been a trend of higher lows, as we begin to see an upward drift in the monthly highs beginning in June 2013. As of June 2014, the real median income has trimmed a bit over half the post-recession decline."
While median household income has recovered somewhat since the lows of 2011, it has been a very unequal recovery overall. Median incomes are still lower overall than they were prior to the financial crisis which speaks volumes about the "real economic recovery." The ramifications of this, simply, is that the cost of living is substantially higher today than it was six years ago. The"gap" between incomes and living requirements has crimped consumption for a large majority of the middle class which keeps economic growth subdued.
Brad has it right. It is time to call the current economic environment what it truly is, and to realize that it is likely to be with us for much longer than most currently expect.
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