Friday, April 27, 2012
Will U.S. Follow Europe Back Into Recession?
While the news that Europe is back in recession is not surprising, it is still troubling.
This week, Britain's Office for National Statistics reported that in the first quarter of this year Britain's economy shrank 0.2 percent, after having contracted 0.3 percent in the fourth quarter of 2011. That makes this Britain's first double-dip recession since the 1970s.
Officially, two consecutive quarters of shrinking GDP indicates a nation is in recession.
It's been four years since Britain's real GDP peaked in the first quarter of 2008. At the end of the first quarter of 2012, its GDP was still 4.3 percent below its pre-recession high. That's telling. It indicates that Britain never truly recovered at all.
On Monday Spain officially fell into recession, for the second time in three years. This means the Iberian nation is now grappling with a rather rapid double-dip recession. The Spanish economy is projected to contract 1.8% this year, according to the International Monetary Fund. Bad news.
Naturally, the credit ratings agencies have taken notice.
Standard & Poors downgraded Spain by two notches on Thursday, from "A" to "BBB+", saying the country's budget problems are likely to worsen due to economic weakness. The contracting economy will ultimately expand the nation's debt. S&P also assigned a negative outlook, meaning it may downgrade Spain again in the near future. The lower rating will likely raise Spain's borrowing costs, which is the last thing it needs right now. Moody's had previously cut Spain's credit rating by two notches back in February.
The pain in Spain is widespread. The Spanish unemployment rate is a whopping 23.6%, with youth unemployment at a stunning 49%. That's akin to a full-on depression. Spanish home prices dropped more than 11% in the fourth quarter, year-over-year. And in December, mortgages collapsed 39%. That's also akin to a depression.
Amidst all of this gloom, the Spanish government is following other European nations in trying to reduce its deficit through painful austerity measures. Many doubt that this will do anything but shrink the country's GDP, making it even harder to repay its debts.
"Austerity itself will almost surely be disastrous," said Nobel Prize-winning economist Joseph Stiglitz. "It is leading to a double-dip recession that could be quite serious. It will probably make the Euro crisis worse. The short-term consequences are going to be very bad for Europe."
The fear is that Spain may eventually follow in the footsteps of its smaller euro-zone partners — Greece, Ireland and Portugal — and need its own financial rescue. The problem is that there is no mechanism in place to bail out Spain. It's simply too big to save and there isn't enough money to rescue it.
Like Spain, Italy is another economic zombie, shouldering a Greek-like debt-to-GDP ratio of 121 percent. And, like Spain, it is also too big to save.
Data released earlier this month showed no growth in France's economy in the first quarter. It seems highly likely that France is now contracting as well. Europe is so interconnected that these things have a tendency to spread. If Germany — the continent's economic powerhouse — follows, it would be a most ominous outcome.
These are huge economies we're talking about here. A European recession will have global consequences. Germany has the world's sixth biggest economy; the UK is ninth biggest; France is 10th; Italy is 11th and Spain is 14th.
As a whole, the European Union has the world's biggest economy. When Europe gets sick, the rest of the world can get sick along with it. Recessions can be contagious and are often global.
Even China's massive economy is slowing from its torrid double-digit growth rate. The global demand for goods is declining and this will affect all exporters, including the U.S. That could result in higher unemployment here and elsewhere.
Yes, this could get ugly.
Due to widespread deficit and debt problems, European governments have been making large budget cuts. But the private sectors in most of these economies have been struggling for years. The only thing keeping most of them afloat has been government spending. That's where all the debt came from.
So, cutting spending, while seemingly necessary, will have the unintended consequence of cutting into GDP as well. That will hurt the European economies and cut tax receipts, which will only make the debt problems worse. It's a downward spiral in which the medicine only makes the patient sicker.
While the ratio of a nation's debt relative to the size of its economy is often viewed as critical, what is more important is the size of a nation's revenues. That's what allows a country to pay its debts.
Which brings us to the U.S.
Absent the government's deficit spending, real GDP has been flat for 15 years. Without the growth in government debt, the U.S. would be in a depression. Perhaps the deficit spending was the lesser of two evils, but now the government has an absolutely massive debt problem on its hands.
After the November elections, Congress will have nine weeks to make a whopping $5 trillion in tax and budget decisions. Even if it weren't for all of the ugly partisan politics the process will surely involve, it would still pose an incredibly difficult challenge and be very unpopular with voters. There is a whole lot less money to fund the government these days, yet there are even greater needs.
The U.S. is still dealing with the hangover from the Great Recession. During any recession, GDP and revenue invariably decline, while safety net payments increase.
In 2010 the federal government brought in $2.16 trillion in revenue — down from $2.56 trillion in 2007 — putting revenue at a 60-year low.
According to the Congressional Budget Office (CBO), automatic stabilizer payments (such as unemployment and food stamps) are adding significantly to the budget deficit. And with 22% of the workforce either unemployed or underemployed, GDP cannot reach its full potential.
The CBO estimates that automatic stabilizers added the equivalent of 2.4 percent of potential GDP to the deficit in 2010, an amount somewhat greater than the 2.1 percent added in 2009.
Millions of Americans remain in dire straights and this is adding to the deficit. These people are not contributing to government revenues, but are instead relying on them. This is not about to change any time soon. In fact, if the U.S. drifts back into recession, the ranks of the needy are certain to grow.
Since the financial crisis, only about 15 percent of the total debt increase was due to the 2008 bank bailout (Bush) and the 2009 stimulus (Obama), according to the CBO. The rest was the result of a huge drop in federal revenues. Absent a rather immediate and significant reduction in unemployment, revenues will not improve.
As it stands, revenues haven't rebounded much and that's a bad sign for the government, the annual deficit and the total debt — now $15.6 trillion, and climbing.
Though the U.S. has added nearly two million jobs over the past two years, the economy is still down about five million jobs since the recession. The unemployment rate has been falling because so many people have dropped out of the work force. That tends to lower the total percentage of those officially defined as unemployed.
The labor participation rate fell steadily after the recession began in 2007, yet it has continued to fall ever since the economy started its 'recovery' in 2009.
An alternate measure of the jobless rate is the employment-to-population ratio, which paints a more sobering picture of the employment outlook.
After peaking at the end of 2006 at 63.4 percent, the portion of the 16-and-over population holding a job (excluding those in prison, the military, or long-term care) fell to 58.2 percent by the end of 2009. Since then, the ratio has barely budged — rising by less than half a percentage point.
That's not good for the revenue side of the equation.
While a solid argument can be made that the U.S. government needs to reduce spending, such action will result in some very heavy consequences. What the government really needs, above all else, is more revenue. Without it, the U.S. will be attempting to bail out a sinking ship.
I'm not arguing that the U.S. doesn't have to reduce its deficits, and eventually its debt. It clearly needs to do both. The country's debt burden is massive and potentially crippling. What I am saying is that the U.S. is caught between a rock and a hard place, with no good choices any more. We're damed if we do, and damned if we don't.
The U.S. will surely follow Europe's lead and initiate its own round of austerity measures in 2013. The budget cuts will shrink GDP, thereby shrinking revenues. Even if those cuts result in a lower deficit (they will by no means eliminate it), they will not reduce the underlying debt. Consequently, the smaller GDP and lower revenues will only raise the debt-to-GDP ratio.
The ratings agencies won't like that one bit. You can expect the U.S. to be downgraded yet again, probably next year.
Congress should have cut the government's budget when unemployment was low and wages were stronger. But cutting spending during this time of high unemployment and stagnant (or declining) wages will only cause unemployment to rise even further, which will reduce revenues even further.
Cutting the safety net payments that millions of Americans rely on will also increase the chances of social unrest. Desperate people do desperate things. It could ultimately result in the kind of social upheaval not seen in the U.S. since the 1960s.
Such unrest has already begun in Europe. Will the U.S. follow Europe down that road?