Storm Clouds Gathering: 'Time To Get Balance Sheets In Order'
The U.S. economy is in a "critical" year and faces the possibility of a recession in 2006, according to the head of a closely watched economic outlook.
Ed Leamer, director of the UCLA Anderson Forecast, told attendees of WesCorp's Future Forum conference here 2004 was a "great year." Highlights included GDP (gross domestic product) growth over 3% in each quarter and more than two-million payroll jobs added.
But how long can it last? "We think 2005 will be a critical year. It features a big wrestling match: the housing bubble and the productivity miracle on one side, versus reality and reason on the other," Leamer declared. "[Federal Reserve Chairman Alan] Greenspan has a heavy bet on the first team because he has a retirement party coming up."
Housing is where consumer downturns get started, Leamer explained. A decline in the housing sector usually is a predictor of a recession. Of the 10 recessions in the U.S. since World War II, eight have involved a sharp decline in real estate spending.
Economists have been discussing the "housing bubble" for several years, but it has not materialized because of the support of the bond market, he asserted. Interest rates have remained low, possibly making the eventual decline more painful.
Businesses are passengers of recession, not drivers, said Leamer. Equipment and software spending does not fall until the economy is in a recession. "Homes and cars are predictors," he said.
"Of all the components of GDP, only one -housing-predicts future GDP growth. The monetary steroids given in 2001 with a substantial lowering of interest rates kept the bubble strong. Now, the prescription has expired," he argued. "Greenspan suffers what I like to call 'Deflation Dread Disorder.' This has kept interest rates low into 2004."
There were three imbalances during the "Internet Rush," a term Leamer uses to describe the euphoric period of 1997 to 2000: first, corporate imbalances, or "business investment as if profits weren't the goal;" second, consumer imbalances demonstrated by a negative net national savings rate during the period; and, third, a global portfolio imbalance - putting all eggs in the U.S. basket.
According to Leamer, problem one has been resolved. After some painful lessons earlier in the decade, corporate profits are up. "Problem two is still ahead of us. There needs to be a correction of the consumer imbalance. Problem three also is still here. Imports not only exceed exports, they are dangerously deficient," he said.
What Lies Ahead?
The job market likely will remain highly favorable for at least another year, said Leamer, but the financial markets will be tough on housing. Long-term rates will rise, with a flattening of the yield curve, slower appreciation of prices-and outright price declines in some markets.
"This very fragile housing market leads to two scenarios: the first is benign-low interest rates go up slowly and eliminate housing appreciation. The second is malign-inflation news forces the Fed's hand, causing more rapid raising of rates."
Leamer compared the current housing market in California to that of the early 1990s. The last time prices were this overheated, they fell 27% over a five-year stretch.
On the bright side, he continued, the "productivity miracle" may save the day. Productivity is up sharply since 1998, and has had a significant effect on GDP.
Leamer's overall U.S. forecast calls for 3% growth in the first half of 2005, slowing to 2.6% growth in the second six months of the year.
In 2006: "Storm clouds are gathering. Now is the time to get balance sheets in order. The expansion has been credit-driven. The housing bubble will get weaker and lose out to reality and reason unless the productivity miracle keeps things going. Two other things to worry about are a low savings rate and a dependence on foreign borrowing to finance our investment."