Economists See Slow Progress to Recovery

To put it mildly, these are unusual economic times, and based on even the most optimistic forecasts, any executive planning on a quick and robust recovery is committing business malpractice.

That's the temperature reading of economic experts interviewed for this look at prospects for an economic recovery, both in the short- and long-term. Our experts advised the Madison business community to fasten its seatbelts and, if possible, build their cash reserves to weather sluggish business conditions and tighter credit markets that are likely to exist for the foreseeable future.

The long, hard slog they envision could be prolonged by other shoes that are yet to drop. For every positive sign of economic "green shoots," such as large banks passing stress tests and the raising of tens of billions of dollars in new equity, there are ominous threats — exploding national debt and the prospect of more home foreclosures — that could undermine economic progress.

And now there are growing doubts about the federal government's attempt to reignite the economy. Earlier this year, Congress and the Obama administration decided to flood the market with government funds to replace vanishing private funds, but despite the $787 billion boost they tried to give the economy in the American Reinvestment and Recovery Act, only about 10% of the money has been spent and the economy is not yet on any kind of visible recovery path.

At this writing, there was talk of yet another stimulus bill, a trial balloon that many Republicans — and even supporters of the original stimulus program like Senate Majority Leader Harry Reid, D-Nevada — were very eager to pop.

Falling Short

The roots of this economic disaster are widely acknowledged — bad mortgage instruments and other leverage that resulted in "toxic debt." Large banks became insolvent primarily because they made poor investments in subprime mortgages. When everyone understood the big banks were in trouble, a run on the banks and a massive credit crisis ensued.

We're still mired in that credit crunch, and are likely to remain so for awhile. For the remainder of 2009, John Oros, managing director of the Wall Street investment firm J.C. Flowers & Co, believes the economy is going to move slowly no matter what direction it takes. "I think the economy is going to have some rough sledding for the next few quarters," Oros predicted. "I would dispute the concept that we're going to have any kind of a big or meaningful bounce back."

Michael Knetter, dean of the University of Wisconsin-Madison School of Business, is one of the optimists, but even he is cautious. He anticipates positive growth in real output in the latter half of 2009, but he concedes that a robust recovery will be a slow process.

"In terms of production, we're nearing the bottom right now and things will turn," Knetter said, "but it will take longer for the labor market to recover because early in the output recovery, firms are going to try to boost productivity and do more with less, which is pretty normal."

Knetter thinks the U.S. eventually will lead the world out of the recession, thanks to aggressive government policy and the nation's inherent advantages in technological innovation.

"We've had a more aggressive government policy response," he said, in reference to the American Reinvestment and Recovery Act. "Government has jacked up demand quite a bit in this country, and that will largely accrue to the benefit of U.S. producers. That's providing a little bit of stability in the face of this decline in consumer spending."

Part of the short-term difficulty is the lack of credit availability, which is likely to continue. Foley & Lardner's Tim Crisp, an attorney with the firm's finance & financial institutions practice, said credit is not going to be as available as it has been in the past because many companies' revenue numbers are significantly down over the past year, while others have suffered recent losses and their asset values from a collateral standpoint are not what they once were.

Not only are borrowers having a more difficult time with credit and its terms, banks and other lenders are having a tougher time gaining the capital they need to lend. "I think it's going to take a good long time, if ever, before we get back to the free-wheeling days when banks and non-bank lenders would offer as much cash as borrowers wanted on very, very cheap terms," Crisp said. "There was a period in which there were loans that were made because banks were driven to increase the amount of loans they had on their books and they were pricing them as though there was no risk in that.

"Now everybody realizes there is risk in those and I think it's going to be a long time, if ever, before we return to those days. In terms of general credit availability, I think it's going to be well beyond this year when we return to any semblance of what life was like before 2008."

Inflationary Future?

In the longer view, many are predicting that the global economy is headed for double-digit hyperinflation, especially once economic growth occurs, and the only therapy to the inevitable inflationary psychology will be to force another contraction — hence the term double-dip recession — with restrictive monetary policy (higher interest rates).

Morris Davis, assistant professor of real estate and urban land economics at UW-Madison, once served as an economist for the Federal Reserve Board. He believes the most likely scenario is a sizeable increase in the price level, but not hyperinflation. The reason is that the unemployment rate is high, which means that the Federal Reserve will want to keep interest rates low. He doesn't know how much the price level will increase, but he believes the Fed will have the teeth to fight a moderate level — 5% per year — of inflation, especially if the unemployment rate is above 8% per year. "We will not have hyperinflation," Davis assured. "The Fed will fight that, but we are in an unsustainable situation right now with regard to inflation and the federal deficit. At some point over the next three years, the government must reduce its spending or increase taxes."

Knetter also believes the Fed has enough levers to avoid a substantial increase in inflation. "Hyperinflation is a serious word, and I don't throw that around lightly," he said. "I find it hard to imagine that the world won't see some kind of generalized increase in inflation. I think the U.S., because of the enormous intervention by the Fed, faces some real risks of inflation, but I also believe the Fed has the strongest incentive to avoid it."

Knetter said the closest thing to a free lunch is the fact that many countries use U.S. Treasury securities and dollar-based reserves to support their currencies. Therefore, the Fed is more motivated than any Central Bank to maintain discipline on inflation because the U.S. wants the world to continue to use the dollar as a reserve currency.

"The dollar will lose favor as a backup currency if the Fed loses discipline on inflation," Knetter warned. "If it loses favor as a reserve currency, then you kind of lose your free lunch. That's a lot of our assets that other countries hold, and that's a very valuable thing to have in your back pocket."

For the Fed to focus on inflation, however, Knetter said it will have to unload some of the securities on its balance sheet as the economy improves, and "that's going to mute the pace of recovery a little bit."

Oros acknowledges the long-term inflationary threat, but noted that deflation is the short-term worry. The inflation rate in May was a negative 1.28%. "I think that all of the things being done now, if left unchecked, would be disastrously inflationary, but the devil's in the details," he said. "Right now, the bigger fear is deflation rather than inflation. Prices are headed down, not up.

"There are major areas of the economy where there is going to be further deterioration of prices — commercial real estate for example. Housing isn't going to stop going down this year or into the middle of next year. Until housing stops going down, we don't have a chance for a sustained recovery."


Long-Term Forecast

As long as the government does not interfere too much in the marketplace, Davis forecasts long-term growth due to innovation and technological progress, which he said ultimately leads to productivity growth.

Productivity growth occurs when the existing workforce produces more output per hour, and it ultimately is associated with a higher standard of living because Americans consume about 70 percent of what they produce. In the past 10 years, the highest quarterly productivity increase was in the third quarter of 2003, when it grew 8.9%. In the first quarter of 2009, it grew by 1.8%.

"I believe the biggest risk to productivity growth is government meddling," Davis opined. "This is true across the planet, so why shouldn't it be true here?"

Knetter said the U.S. still leads the world's knowledge economy industries, and that's what gives him faith that the U.S. will be well-positioned coming out of the recession.

"To the extent that there is a market-based capital catalyst for recovery, I believe that will be spending on technology by firms and to some extent by consumers," he said. "I think technology is more important, not less important, going forward, and I think the U.S. is still the leader in innovative technology solutions that boost productivity and innovative technologies that are of interest to consumers."

To gauge recovery, Knetter said he will be looking for signs of stabilization in the job market, further progress in the housing market, and consumer spending. "Consumer confidence and consumer spending — that's ultimately what has to turn around," he said.

While Davis focuses on technology spending and productivity as things that will lead us out of the wilderness, he does not dismiss the role of housing. He said foreclosure filings are going to rise due to the surge in unemployment — now 9.5% nationally — and the fact that so many homeowners are "under water," meaning the value of their homes is less than amount of the mortgage.

Secondly, since foreclosures tend to sell at a 20% discount relative to similar homes, the increase in foreclosures will drive down reported estimates of house prices. "I suspect measured house prices will fall by another five to 10 percent nationwide, and then bottom out in early 2010," Davis predicted.

Oros also looks at the housing market. "I know it doesn't matter to someone in Madison, Wisconsin whether they've got a lot of excess [housing] inventory in San Francisco, but how many houses are for sale relative to the absorption rate?" he asked. "Right now, there are about five million houses for sale in the United States. In a good year, we can sell about two million, so we've got two and one-half years' over supply of housing."

Economic Neutron Bomb?

If subprime mortgage loans are the major cause of the recession, the ticking time bomb known as Option ARM mortgages could help prolong it. Option ARM mortgages, another mortgage product undone by declining home values, have been compared to the neutron bomb because of their potential to "wipe out" people financially while leaving their houses standing.

As its acronym implies, Option ARMs are adjustable rate mortgages. They begin with a "teaser rate," usually 1 or 2% for a limited duration, which eventually "resets" to the real interest rate. Option ARMs bring the very real risk of negative amortization, where the principal balance of the loan can increase over time and usually is capped at 110%, 115%, or 125%. If the loan balance gets to one of these preset thresholds, the loan can be recast without warning.

The payment then is recalculated to include interest at the current rate and to fully amortize principal over the remainder of the term, creating risk factors like payment shock (the monthly payment can more than double) and reduced equity as interest is not paid and added to principal.

In the current climate, low-income borrowers cannot refinance because the value of their home has not increased or has declined; because most or all of their equity vanishes, they don't have the income to support higher payments.

According to Wes Becker, a transactional lawyer and a partner with Foley & Lardner, there appears to be between $500 billion and $750 billion of Option ARM loans outstanding. The default wave may already have begun and is not expected to peak until 2011. Analysts expect default rates to reach 45% to 50%, leading to more home foreclosures, more losses for financial institutions, and a very strong economic headwind. "I think this certainly is an anchor on any kind of recovery and is going to hold it back," Becker stated. "Will this alone tank the economy against lots of stimulus, really low interest rates, and other things? Hard to say, but this certainly is a very strong headwind."

Another potential obstacle to recovery is the exploding national debt. The national debt now stands at $11.4 trillion, or about $37,000 for every American, and interest payments on the debt cost $452 billion in 2008. This year's deficit is now estimated at about $1.85 trillion, and with more record deficits on the way, some worry that excess debt will become a lingering economic drag.

The debt is financed mostly by the sale of Treasury bonds and bills, but because high levels of spending weakens the value of the dollar, these securities become less attractive investments. Foreign lenders already are paring back their purchases of U.S. securities; were these debt holders to flee in larger numbers, interest rates could rise sharply.

Under that scenario, interest rates have to go up a lot because "we hold the debt ourselves," Knetter explained. He added that further indebtedness was necessary to avoid an economic catastrophe. "When people's expectations turn negative enough, it's a self-fulfilling downward spiral," he stated.

King Cash

Oros spoke for all of our experts when he offered this advice to small businesses in Madison. "Cash is king," he said. "Hold on to your cash."

Crisp agreed, saying liquidity is important because of the credit difficulties companies are having. "If you have cash reserves and haven't over extended yourself," Crisp said, "you're in a much better position to navigate the next few bumps in this bumpy road."