Monday, July 11, 2011

Yes, these Hard Times will end

- by New Deal democrat

After a brutal week like last week, and a brutal report like Friday's June jobs report, it helps to step back and take a few deep breaths.

Yes the report was awful, and in almost every respect. Even the leading parts of the report, especially manufacturing hours, declined. Substantially.

Further, it's hard not to be discouraged by the nonsense coming out of Washington. In the face of the worst continuing economic conditions in over 70 years, austerity reigns triumphant. Austerity will not work. It will make matters worse. That Social Security and Medicare are being served up allegedly as part of a "Grand Bargain" but really just for the first course, is even more discouraging.

All of this is bad. But at the same time, please remember that we had Panics and Depressions all through the 19th and early 20th centuries, some worse than others, and all of them eventually resolved even though there was no New Deal or stimulus program to assuage the most needy.

Let's start by remembering that what got us into this mess was too much debt, and specifically a housing bubble that burst, eventually dragging down everything including a highly leveraged financial sector with it. But eventually these factors - the housing bust and the household debt issues - are going to be worked out, and turn into positives. A time horizon of the next two or three years is not unreasonable.

The first factor is the housing market. Here's a graph of housing permits and starts for the last 10 years:

The bad news is that the housing market has been flat on its back for the last 2 1/2 years. That housing hasn't participated is a very big reason why the recovery from the trough of the "great recession" hasn't been enough to translate into real improvement in people's lives. As Prof. Edward Leamer has compellingly shown, typically housing leads both in recessions and in recoveries, creating jobs not only for construction workers, but also having huge multiplier effects over a year or two, as new homeowners buy furnishings, appliances, landscaping, and other improvements both interior and exterior.

The good news is that it's hard to generate a significant economic contraction without housing participating in that, either. In other words, if there's been no upturn, there also hasn't been any significant downturn in housing sales in the last 2 1/2 years. So, we might face stagnation, or in the worst case, a relatively shallow double-dip. That would make a bad situation even worse, but on the other hand, not Armageddon.

And as I pointed out last year, the Millennials or Echo Boomers are arriving at home-buying age. Demand is beginning to get pent-up for these first time home-buyers. Meanwhile prices and mortgage rates have continued to decline, so that housing affordability (meaning how big of a monthly payment is necessary to own a house via a mortgage) is at multi-decade lows. So once housing does begin to improve, the expansion it creates may very well resemble an economic opening of the floodgates.

The second factor is the accumulation of personal savings. Here is a graph of inflation-adjusted, "real" personal savings for the last 50 years:

As you can see, for the last 2+ years, more savings have been accumulated than at any point in the last 25 years. There are $100s of Billions of dollars more than before the recession that can be spent, once the confidence and opportunity arrive to do so. Inevitably this is skewed towards top earners, but this has always been the case, even if moreso now than at any point in over half a century.

The third factor is the deleveraging of households. Here is the latest graph of the percentage of disposable income needed to service household debt:

This data is already over 3 months old. If deleveraging continues for the next 8 months like it has since the middle of 2008, households will probably be in their best position to service debt in the last 30 years.

Unless there is some major new event, within about two or three years we are going to have households much more able to pick up spending, and a housing market ready to take on some of that pent-up demand. It's also worth noting that with new discoveries coming online, and more energy-efficient vehicles being sold over the next 3 years, Oil's choke collar is also likely to loosen.

On the other hand, I do have one big concern, and that is the issue of wage deflation. We just had our second (tiny) outright monthly decline in hourly earnings in the last seven months. We have had this before, most particularly in the mid-1980's, so it isn't necessarily fatal. Indeed, as the below bar graph of the last 30 years shows, hourly earnings tend to hit their cycle lows several years into a recovery, so the present is consistent with those past expansions:

But here is a graph showing the quarterly trend in hourly earnings in the last 10 years:

We need to see renewed strength in wages soon. If the current trend continues, then within about 2 years or so we are going to tip over into outright wage deflation. We very much need to see the three positive factors I've outlined above kick in before a debt-deflation is triggered. As I wrote last January, we are in a race between deleveraging and deflation. I do consider it likely that deleveraging will win.

Once housing begins to improve again, household deleveraging has been accomplished, and Oil's choke collar loosens on a more sustainable basis, these Hard Times will end. How much of an improvement we will see at that point will depend on how much actual wages grow.