Higgs on the Economic Recovery

If consumer spending were the key, the economy would be going strong. Real consumer spending peaked in the fourth quarter of 2007, fell slightly (about 2.5%) over the next six quarters, and by the fourth quarter of 2010 exceeded its previous peak by almost 1%. So it is clear that a "collapse" in consumption is not to blame for the economy's anemic recovery.

What is to blame is the collapse of private business investment. Until this critical component of the economy — technically, "private domestic business net investment" — fully recovers, the economy will continue to sputter.

Don't confuse net investment with gross investment.

Gross investment includes expenditures aimed merely at maintaining or replacing existing structures, tools and equipment, software and other capital goods as they become obsolete or wear out.

But unless firms do more than make up for depreciation, they do not expand their productive capacity, except to the extent that they replace worn-out or obsolete capital goods with models that employ improved technology. If all we do is replace a worn-out machine tool with a new one, we have not increased the number of machine tools.

Economic growth requires net investment — investment above and beyond the replacement level — and more rapid economic growth requires a greater rate of increase in such investment.

With that in mind, consider what has happened to net private investment.

Net private investment reached its recent cyclical peak in the third quarter of 2007, when firms were investing at a net annual rate of $463 billion per year. (In that same quarter, gross business investment was running at a $1.66 trillion annual rate.)

Net investment then fell steadily for the next four quarters, reaching $336 billion in the third quarter of 2008 and plummeting to $159 billion in the fourth quarter of 2008, a 53% drop in a single three-month period.

Although the financial-market panic that flared up in September 2008 began to subside early in 2009, net investment continued to fall, going into negative territory (minus $53 billion annually) in the first quarter of 2009 and falling further to minus $119 billion in the second quarter of 2009.

Some improvement began in the next quarter, but for the entire year 2009, net business investment amounted to minus $69 billion. Hardly by coincidence, U.S. gross domestic product also fell substantially in 2009...

Unless private investment recovers more rapidly, the economy's recovery is sure to remain slow, too slow to significantly lower unemployment...

A substantial, rapid recovery of net private business investment probably won't occur until the made-in-Washington clouds clear. Meanwhile, overall economic prospects will remain gloomy.

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4th Quarter 2010: Revised Down to 2.8%

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The Fed and Money Expansion

To understand how the receipt of new reserves influences a bank's behavior, the place to start is to ask whether the bank is willing to hold the reserves overnight. Prior to 2008, a bank could earn no interest on reserves, and could get some extra revenue by investing any excess reserves, for example, by lending the reserves overnight to another bank on the federal funds market. In that system, most banks would be actively monitoring reserve inflows and outflows in order to maximize profits. The overall level of excess reserves at the end of each day was pretty small (a tiny sliver in the above diagram), since nobody wanted to be stuck with idle reserves at the end of the day. When the Fed created new reserves in that system, the result was a series of new interbank transactions that eventually ended in the reserves being withdrawn as currency.

All that changed dramatically in the fall of 2008, because (1) the Fed started paying interest on excess reserves, and (2) banks earned practically no interest on safe overnight loans. In the current system, new reserves that the Fed creates just sit there on banks' accounts with the Fed. None of these banks have the slightest desire to make cash withdrawals from these accounts, and the Fed has no intention whatever of trying to print the dollar bills associated with these huge balances in deposits with the Fed.

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$61 Billion Budget Cuts

Talk of a government shutdown is heating up. The current continuing resolution funding the government is set to expire on March 4th. Last week, House Republicans passed a bill that would fund the remainder of fiscal 2011 at $61 billion below fiscal 2010 levels. Senate Democrats are balking at the $61 billion in cuts and the president has issued a veto threat.

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Current Market: S P 500

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CPI and PCE

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CPI Categories

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Federal Taxes

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Composition of Federal Spending

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Federal Payments to Individuals

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Real GDP per Capita

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World GDP per Capita

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Budget Deficits: A Spending Problem

The new Congressional Budget Office (CBO) 10-year budget baseline shows a virtually unprecedented sea of red ink. The report reveals an unprecedented $1.5 trillion deficit in fiscal year (FY) 2011—an increase of $95 billion over their last 2011 estimate.[1] This will be the third consecutive year of trillion-dollar deficits.

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US Manufacturing

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January 2011 Unemployment: 9.0%

The Labor Department reported nonfarm payrolls rose by just 36,000 in January while the unemployment rate fell from 9.4 percent to 9.0 percent, the lowest level since April of 2009.

Though hiring in the manufacturing sector was quite strong, the nonfarm payrolls gain was disappointing, well below the consensus estimate of 140,000.
The drop in the jobless rate was a pleasant surprise was also disappointing as it was due largely to more workers finding jobs leaving the rather than a shrinking labor force. The broader U-6 measure of unemployment, including those who have stopped looking for work and those settling for part-time work, fell from 16.7 percent to 16.1 percent.

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According to the Bureau of Economic Analysis (BEA), real GDP is now slightly above the pre-recession peak. Real GDP (in 2005 dollars) was at $13,382.6 billion in Q4, just 0.14% above the $13,363.5 billion in Q4 2007.

However industrial production is still 5.8% below the pre-recession peak, and it will probably be some time before industrial production returns to pre-recession levels.

Payroll employment is still 5.6% below the pre-recession peak. And even with slightly above trend GDP growth in 2011, payroll employment growth will probably only recover slowly. Payroll employment is still 7.7 million below the pre-recession peak, and if the the U.S. adds 2.5 million payroll jobs per year over the next 3 years (my current forecast is 2.4 million private sector jobs this year), it would take 3+ years to return to the pre-recession peak. And that doesn't include population growth!

This graph shows real personal income less transfer payments as a percent of the previous peak.This has been slow to recover - and is still 4.3% below the previous peak.

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Cartoon: Oil Prices

Cartoon: Needs