Less Than A Bubble, More Than A Burst

Less Than A Bubble, More Than A Burst Randall Dodd Financial Policy Forum EPI Brownbag November 1, 2002

COINCIDENT INDICATOR. • Payroll employment picks up the turning point like it did in 1990. Although in the present case the turning point was not nearly so sharply defined.

COINCIDENT INDICATOR. • Industrial production picks up the turning point early in this cycle, but not far from the three month lag in the prior recession.

COINCIDENT INDICATOR. • Total business sales (retail, wholesale and manufacturers) picks up the turning point, and does so in a sharply defined manner. Figures are seasonally adjusted but not adjusted for inflation.

COINCIDENT INDICATOR. • Crude Oil prices is not a typical coincident economic indicator but it worth a look. The price hike occurred after the prior recession started (note bold vertical lines in chart) and the hike started prior to the current one. The high prices nonetheless acted as a drag in both.

LEADING INDICATOR. • New orders for investment goods picks up the turning point almost six months early, and does so in a sharply defined manner. Figures are seasonally adjusted but not adjusted for inflation.

Unlike in prior recession, real consumption has not declined. The pace of growth has slowed in comparison to the last half of the 1990s. If the Wealth Effect has played a role, it has not been strong enough to turn consumption negative. (annual rate of % change from quarter to next)

Unlike in prior recession, real consumption has not declined. The pace of growth has slowed in comparison to the last half of the 1990s. If the Wealth Effect has played a role, it has not been strong enough to turn consumption negative. (Amount change from quarter to quarter.)

Real Weekly Wages Stay Up. • They don’t continue their progression upwards, but by staying up they sustain consumption.

Wealth is likely to have dampened consumption spending, but not much. It appears to have had an arresting impact on real retail sales. Retail sales make up 50% of Consumption, health care and housing make up another about 15% each. The remaining 20% is an unknown for me. Stock market peak

Household Debt -- nominal value, SA • Consumer debt, in nominal terms, has risen throughout the recession (unlike the decline in non-revolving debt during the prior recession). Growth in revolving, i.e. credit card, debt has flattened off considerably only to begin rising again in the last few months.

Auto Debt - rate and terms • Rates have fallen substantially since the start of the recession, and the terms of credit have also eased at maturity has risen and the loan/value has jumped up. (At finance companies, terms are not as favorable at banks.)

Household Debt - Mortgage Debt • Total home mortgage debt owed by households has risen rapidly and has not been affected by the recession. Home Equity debt, which is a component of total household mortgage debt, has risen far more rapidly since early 1999 and the torrid pace has slackened only slightly since2000:III.

Mortgage Interest Rates. • Rates have fallen substantially since the start of the recession, after rising through 1999 and first half of 2000.

While the amount of total household debt and consumer debt have increased greatly, the cost of debt service (principle and interest) as a percentage of disposable household income has NOT. In fact current ratios are lower than in the mid-1980s and no more than 2% points higher than the beginning of the decade. This cannot explain much of the slower pace of consumer spending.

• Delinquencies at banks are not high, especially in comparison to the last downturn.• Delinquencies at banks (where payments are 30 days past due) are measured as the percentage of debt written-off and expressed as an annual rate for each month. This does not include debt at non-bank financial institutions.

Although delinquencies are not high, especially in comparison to the last downturn, the amount of charge-offs is rising.• Charge-offs are measured as the percentage of debt written-off and expressed as an annual rate for each month.

Wealth Effect • Most losses likely amongst richest 9%. In 1998, the SCF showed that 80% of total unrealized capital gains were amongst the top 9%. • SCF (1998) showed that stock ownership concentrated amongst wealthiest 10% of households (82.2%) and top 1% (42.8%). Bottom 89% held less than 18%.

Both the large cap S&P500 and the NASDQ Composite peaked about the same time in March of 2000. This differ in how they have fallen before and after September 11th and before and after October 16th of 2002 (hereafter known as Enron Day. The NASDQ Composite fell 66% from its peak by September 10th, then rose 9% by Enron Day and has then fell again by 35% by October 9th 2002. The S&P500 fell 28% from its peak to September 10th, then rose 6% by Enron Day and then fell 29% by Oct. 9th.

Margin Debt • The chart shows that the use of margin debt (debt/market capitalization) declined sharply starting in 1986 as the bull market gathered steam. Margin debt flattened out in 1991, was up and down a bit until 1995, while the bull market charged onwards. When margin use rose decidedly in 1998 it did so as the market rose to its peak in March 2000. They fell together, then margin use surged and then fell back again.

Margin Debt -- smaller interval • The chart shows that the use of margin debt (debt/market capitalization) declined sharply starting in 1986 as the bull market gathered steam. Margin debt flattened out in 1991, was up and down a bit until 1995, while the bull market charged onwards. When margin use rose decidedly in 1998 it did so as the market rose to its peak in March 2000. They fell together, then margin use surged and then fell back again.

Stock Prices: The Bull Charge • Two Reasons • First -- fundamentals • Low inflation, low interest rates • Low volatility of GDP • Long-wave of tech innovation • Longest expansion in US history • Second -- financial • Higher ‘plowback’ rate п • Higher firm specific ROE • Problems • Herding - although with some rational basis, and poor assessment of risk • Difficult to price new technologies • Manipulation from skewed market analysis • Manipulation from false reports on market

Stock Prices: The Bear Dance • Two Stages • First -- March 2000 to Oct 2001 • Fed raised rates starting Spring ‘99 • Rising market volatility • Lowered E1 forecast • First - part two • Sharp fall in long-term E forecast • Second -- Oct. 2001 to Oct 2002 • Despite Fed lowering rates • More market volatility • Worse earnings forecasts • Sharp, negative Enron “corrections” • Some firms lower п

This is a different picture of the role of government expenditure than you might expect. It has become a source of volatility to the U.S. economy! It has has a positive net effect although its magnitude is modest. Non-defense federal spending is also volatile, and has been negative twice since the current downturn.

Note that S&L, while presumed to be more cyclical, has been less volatile from quarter to quarter. Defense spending has been much more volatile from quarter to quarter, and over this period it has been counter-cyclical even if the reason for the changes has not been primarily macroeconomic management.

The role of real net exports has been novel. Usually real imports decline during a downturn due to the fall income and overall consumption and investment spending. This occurred in both the present and prior downturns. This time this was matched with a great degree of correlation by a downturn in exports! This is unusually and suggests that the U.S. economy is more positively correlated with economies in the rest of the world. (Chained ‘96 dollars, and net exports are on right axis.)

The Strong Dollar. • The dollar appreciated prior to the start of the recession and continued up until 2002. Since then it has depreciated against the Euro, Sterling and Yen

The role of Investment appears to play a more important role. While investment in residential structures has played a persistent positive role, that for non-residential structures has turned down and continues to decline. More importantly, investment in equipment turned sharply downward, and is only slowly recovering.

The composition of the changes in investment is telling. Growth is entirely attributed to Information Processing while that for Trans and Industrial continues to decline. (Again chained ‘96 dollars.)

Information processing is comprised of computers, software and other (including communications, instruments, office equipment and photographic equipment). Of these, software declined the least and computers rebounded most quickly. (Again chained ‘96 dollars.)

Change in Inventories. • Inventories took a sharp drop, much larger than in the prior recession. Orthodox Keynesians take note. (Changes from quarter to next in chained 1996 dollars)

Change in Inventories. • Not just the prior recession, but all prior recessions in the post-war era.

Inventories and Inventory Sales Ratio. • Inventory sales ratio rose just as the stock market fell and real retail sales flattened out. The drop in sales pushed up I/S ratio initially before liquidation of inventories (which is shown beginning in early 2001) turned ratio downward.

SUMMARY: CAUSES • Not just any one factor. Over determined as Freud would say, or as the great wit and sage, “we made too many wrong mistakes.” • Three themes: • Market Crash: • Fed raised interest rates and deflated market • Virtuous tech cycle came to an end: part stumble, part exhaustion and part hitting of wall • One word, “Enron” • Rest Of World slowed • U.S. is more correlated with ROW and especially during downturn • US dollar stayed up • Investment Crunch • Tech boom stumbled, played out • Higher interest rates • High dollar • Higher capital costs • Drought of new capital

PROSPECTS • CONSUMPTION • depends on employment and wages • further household debt accumulation less likely, especially if housing prices fall. Maybe more retailer credits. • Wealth effect NOT likely to turn positive in near term. • INVESTMENT • Inventories show little gain even after liquidation • Equipment is coming back, though mostly computers and other info processing. Industrial and transportation and “other” is still slack. • Structures are smaller in magnitude but still declining. This may need to wait upon new business start-ups. Market rebound may help. • Residential has not slowed and thus not likely to speed up and therefore not likely to contribute to turn-around and rebound. • GOVERNMENT • CR for Fed spending, eventually national security spending will surge. • S&L is pro-cyclical, but not in a leading way. • NET EXPORTS • Misery loves company. US growth increasingly correlated with ROW and thus will find downturn is aggravated and upturn is awaited. • Export component did show some growth in 2002:III. • US dollar remains strong, though may drop with another Fed ease.

POLICY PROPOSALS • MINIMUM WAGES • will help consumption • INVESTMENT TAX CREDITS • Bigger bang for buck, and targeted to sector that has turned down the most. • LOWER INTEREST RATES • Fed can lower rates to help stock market, lower cost of capital and possibly ease drought on new capital • REAL REFORM OF FINANCIAL MARKETS • gets financial markets working again. True for energy markets as well as stock markets. • RENEW GLOBAL GROWTH • reform IMF policies towards expansion • resolve LDC debt problems • reform Japanese financial system • reform EU macropolicy to eliminate downward bias • ROLL-OUT BROADBAND • Auction spectrum in order to free resources for further innovation.

Less Than A Bubble, More Than A Burst