In an essay in last week’s City newspaper, former Rochester Mayor Bill Johnson mentioned “Depression era conditions.” It wasn’t clear what he meant—fortunately, however, we’re a long way from reaching such depths of despair. After all, GDP actually rose at a 2.8% rate through the second quarter of 2008. Unlike the 25% unemployment of the Great Depression, we’re just over 6% now. I’ll be astounded if the unemployment rate doesn’t continue to rise and GDP begin to fall—but this isn’t the Great Depression.
A friend asked yesterday if we should mount a “public works” program and attempt to “jumpstart” the economy through direct spending or, perhaps, by encouraging the public to spend more by sending out another wave of government rebate checks.
I explained that every hiccup in the economy (OK, this one is more like a long bout of heartburn) has its own cause and its own solution. In this case we’re not suffering due to a lack of demand. Granted, fear may encourage consumers to spend less and falling tax revenue will force state and local governments to spend less. Moreover, at some point, it may be wise to take action to encourage more spending.
But that’s not why we’re in this particular pickle and a stimulus package won’t get us out.
In some respects, the problem we face now is similar to the one we faced in 1973-74. Then the economy stalled as business struggled with an abrupt increase in cost. The Organization of Petroleum Exporting Countries (OPEC) cartel drove up oil prices while the economy was struggling to absorb the cost of a raft of regulatory legislation—among them the National Environmental Policy, Occupational Safety & Health, Clean Air, and National Water Pollution Control acts. While all were needed and have produced a better quality of life for Americans, these laws were expensive and were driving up cost across the economy at exactly the same time OPEC learned it could charge us a whole lot more for oil.
Oil prices are up again. Despite recent declines, they are still double what they were in 2006. Yet, high oil prices weren’t the trigger for the current decline. Far more critically, we’re facing a “money shortage.” Maybe you don’t think of money the same way you think of oil, but money is part of the production process, too. Most businesses borrow as a regular part of their business. Retailers, for example, borrow money to buy inventory in the fall, then pay it back after the Christmas shopping season has refilled their bank balances. So just as costly fuel can force businesses and individuals to cut back, so can costly money.
In an odd twist of fate, we’re desperately short of money today partly because we had too much earlier in the decade. Yes, you can have too much of a good thing! As it happens, it was a fabulous glut of saving worldwide and successful anti-inflation programs among central banks that drove down the rate of return on investments. Cheap money (i.e. very low interest rates) encouraged sellers of cars, refrigerators and dining room furniture to offer bargain basement financing—“No money down! No payments until January! 0% interest!”
Cheap money spurred a fabulous boom in real estate, the most interest-rate sensitive part of the consumer market. As was accepted wisdom, real estate values never fall, owning is always better than renting, and real estate is the only “safe harbor” for our savings—because it is backed by tangible property.
Managers of investment funds, urged on by fund owners, were desperate to find new ways to earn more than the meager return on savings deposits. The creativity of investment managers was unleashed on the mortgage market. The party got out of control and the chaperones weren’t paying attention.
That real estate was a bubble wasn’t a surprise. In the summer of 2005, The Economist wrote:
According to estimates by The Economist, the total value of residential property in developed economies rose by more than $30 trillion over the past five years, to over $70 trillion, an increase equivalent to 100% of those countries’ combined GDPs. Not only does this dwarf any previous house-price boom, it is larger than the global stockmarket bubble in the late 1990s (an increase over five years of 80% of GDP) or America’s stockmarket bubble in the late 1920s (55% of GDP). In other words, it looks like the biggest bubble in history.
While some are guilty of adding air to the bubble and others for not taking prudent steps to siphon some air out, the underlying cause was the global savings glut.
According to the Case-Shiller Index, a measure of U.S. real estate price movements, current real estate prices remain 55% higher than they were in 2000 (27% after adjusting for general price inflation). With the economy slowing more generally, real estate prices could continue to slide, particularly in some markets. Foreclosures tripped by falling prices and rising interest rates don’t help, either. The rescue plan just passed by Congress is intended to insulate the broader economy from a continued slide in prices and to patch the massive holes blown through the financial system. It will help, although it won’t save us from a period of economic weakness and insecurity.
We can be optimistic that the rescue plan will stop the bleeding, restore confidence and, in so doing, address the shortage of money that threatens to strangle the economy. Extraordinary intervention is justified and timely. Moreover, with sanity restored to the financial sector, ordinary economic forces will place us on a path to stability.
Kent Gardner, Ph.D. President & Chief Economist
Published in the Rochester (NY) Business Journal October 10, 2008
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October 22nd, 2008 at 3:20 pm
Kent,
Thoughtful article. Two thoughts/questions:
1. The real estate bubble seems to have been fueled by a combination of low interest rates, lax lending standards in terms of borrower’s credit scores, allowing no-money-down loans, interest-only loans, the securitization of mortgages, etc. Do you think all of those are a result of a global savings glut? Or are there other fundamental factors that led to those actions?
2. On savings, do you believe that Americans will begin saving much more of their incomes in the coming years than they have in recent years? I think it’s Stephen Roach from Morgan Stanley who is predicting that consumption will fall from 71% of GDP to somewhere in the 60%+ range, more similar to a few decades ago. He argues that Americans were experimenting with allowing asset appreciation to replace their need for savings, but now that the bubble has burst, we’ll return to saving from our incomes. If that’s the case, it’s probably a good thing for individuals, but could that be harmful for the economy as a whole by causing another savings glut or by causing consumption to grow slowly for a number of years?
Personally, I can’t help but think that more savings would be positive for America, but I suppose it’s possible that a positive for individuals might be a negative for society. What do you think?
October 23rd, 2008 at 10:18 am
I completely agree, Steve. The global savings glut made all of the fancy footwork not only possible, but in some sense almost, shall I say, necessary? Certainly necessary to the fund managers sitting on piles of cash that weren’t earning anything in the marketplace. Pushed by investors and competitors to earn higher returns, they took risks that were systemically unacceptable. And that’s where we all got caught–behaviors that appeared to be acceptably risky from an individual’s perspective had created systemic exposure to falling real estate prices.
And we do find ourselves confronting that old “paradox of thrift”–saving is good for individuals but bad for the level of economic activity. I wonder, however, if this is a transitional problem. The rising savings rate will slow the economy initially but, once stablized at a higher level, will have the beneficial consequence of reducing interest rates, thus the cost of investment capital, thus spurring future economic growth. Any macroeconomists out there who can remind me of the net effect here?