Wall Street analysts and economists have this recession recovery wrong
By Barry Ritholtz,
The recession is well behind us now, and Wall Street seems to think this recovery should be all wrapped up.
Consider this: The federal non-farm jobs report for June was pretty awful. The private sector created 57,000 jobs. Federal, state and local governments cut 39,000 positions (the eighth straight monthly decrease in government employment). We picked up a mere 18,000 net new jobs.
Not a single forecaster in Bloomberg’s monthly survey of 85 Wall Street economists got it anywhere close to right. The most common reaction was “surprise.” That any professional can sincerely claim to be surprised by continued weakness — in employment, GDP or retail sales — was the only revelation.
Let’s put the number into context: In a nation of 307 million people with about 145 million workers, we have to gain about 150,000 new hires a month to maintain steady employment rates. So 18,000 new monthly jobs misses the mark by a wide margin.
Why have analysts and economists on Wall Street gotten this so wrong? In a word: context. Most are looking at the wrong data set, using the post-World War II recession recoveries as their frame of reference.
History suggests the correct frame of reference is not the usual contraction-expansion cycles, but rather credit-crisis collapse and recovery. These are not your run-of-the-mill recessions. They are far rarer, more protracted and much more painful.
Fortunately, a few economists have figured this out and provide some insight into what we should expect. Among the most prescient are professors Carmen M. Reinhart and Kenneth S. Rogoff. Back in January 2008 (!), they published a paper warning that the U.S. subprime mortgage debacle was turning into a full-blown credit crisis. Looking at five previous financial crises — Japan (1992), Finland (1991), Sweden (1991), Norway (1987) and Spain (1977) — the professors warned that we should expect a prolonged slump. These other crises had a number of surprisingly consistent elements:
First, asset market collapses were prolonged and deep. Real housing prices declined an average of 35 percent over six years, while equity prices collapsed an average of 55 percent. Those numbers were stunningly close to what occurred in the U.S. crisis of 2007-09.
Second, they’ve noted that the aftermaths of banking crises “are associated with profound declines in employment.” They found that following a crisis, the average increase in the unemployment rate was 7 percentage points over four years. U.S. unemployment climbed 6 percentage points (from about 4 percent to about 10 percent), while the broadest measure of joblessness gained over 7 percentage points (from about 9 percent to about 16 percent). Again, they were right on the money.
Third, the professors warned that “government debt tends to explode, rising an average of 86 percent.” Surprisingly, the primary cause is not the costs of bailing out the banking system, but the “inevitable collapse in tax revenues that governments suffer in the wake of deep and prolonged contractions.” They also warned that “ambitious countercyclical fiscal policies aimed at mitigating the downturn” also tend to be costly.
Hmmm, plummeting tax revenues just as the government tries to stimulate the economy . . . does any of this sound familiar? It should.
Note that the duo published its paper on this in early 2008 — months before Bear Stearns and Lehman collapsed, almost a year before the AIG-Bank of America-Citi-Merrill-Fannie bailouts happened. And at the time, the U.S. stock markets had barely moved off their all-time highs, set in October 2007. After the collapse, they turned their research into a book, “This Time Is Different: Eight Centuries of Financial Folly.”
Credit bubbles are different
Not only are credit crises different from other cycles, they also differ from other bubbles.
As Dan Gross explained in “Pop! Why Bubbles Are Great for the Economy,” the typical investing bubble leaves behind something of value. Whether it was thousands of miles of railroad tracks in the 19th century or thousands of miles of fiber-optic cables in the 1990s, usable infrastructure survives the bubble. Assets get scooped up out of bankruptcy for pennies on the dollar. Eventually, all of this overinvestment in the bubble du jour becomes a productive part of the economy. All that cable laid by Global Crossing and Metromedia Fiber and other bankrupt firms? Today, it is the bandwidth infrastructure that supports Google Maps, Netflix streaming video and Twitter.
Compare that with what gets left behind after a credit bubble bursts: No physical infrastructure, innovations or research breakthroughs; just soul-crushing, economy-sapping debt. And not just regular old balance-sheet obligations, but huge piles of counterproductive consumer and government liabilities.
Credit bubbles produce the exact opposite of productive resources. Deleveragers — those folks formerly known as consumers — spend the next decade paying down these obligations, rather than buying additional goods and services. And heavily indebted state and local governments are similarly thrifty, adding further pressure to the post-crisis economy.
Confusion about this is already taking a toll across the pond. The Irish, British and, soon, Greeks have bought into a misguided belief in austerity — that they can somehow cut their way to growth. In the United States, we have seen states and municipalities slashing head counts of teachers, cops and firemen. The “paradox of thrift” has morphed into a misguided economics of austerity. Hence, even when the private sector manages to create some jobs, its offset by public-sector job cuts.
Painted into a corner
In the not too distant past, the market might have been inclined to rally following a horrific data point such as June’s NFP report. The assumption was that the Fed, or perhaps Congress, would respond to economic distress with its usual largess. But the immediate market reaction — selling off on the “surprisingly” bad number, and then having difficulty all last week — suggests that traders are no longer expecting a cavalry charge to save the day.
Indeed, the Federal Reserve is in no position to do much more without great distress. Markets briefly rallied Wednesday when Fed chief Ben Bernanke suggested that a QE3 was possible. But soon after he finished his congressional testimony, Federal Reserve Bank of Dallas President (and FOMC voting member) Richard Fisher said the Fed had “exhausted our ammunition.” And Thursday, Bernanke scared markets further, saying the central bank wasn’t yet ready to take additional steps to boost the economy.
Markets gave up most of their rally on the recognition that the cavalry might not come this time.
Even with the Fed out of the picture, investors should not expect any relief from Congress: The legislative body in charge of taxing and spending seems incapable of accomplishing much these days. We are more likely to see counterproductive austerity measures than anything else.
Investors, it looks like you are on your own this time.
Ritholtz is chief executive of FusionIQ, a quantitative research firm. He runs a finance blog, the Big Picture.