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Recovery Hits a “Soft Patch”
By Marshall J. Vest
EBR and
Forecasting Project Director
December 1, 2010
A nice recovery was underway in Arizona’s economy during the first half, but since June most of those gains have been given back. The best description now is that Arizona’s economy is bumping along the bottom. We expected conditions to soften during the “payback” period following expiration of homebuyer credits and winding down of federal stimulus spending. What’s surprising is that private sector demand has not been strong enough to keep the recovery progressing. We still expect momentum to build as we move into the New Year and that a “double-dip” will not develop. The best bet is that the recovery will proceed slowly during 2011 due to a multitude of headwinds, and that more robust growth will follow.
The Great Recession ended a year-and-a-half ago. So far the recovery has been slow and disappointing. Nationwide, real GDP declined by 4% during the recession, and since the recession ended, real GDP has grown by 3.5%. It will be at least the first quarter 2011 before the previous peak is regained.
Headwinds are numerous and worrisome. The boost from fiscal stimulus is now fading and inventory rebuilding is nearly complete, so it’s time for consumers and businesses to provide leadership. Unfortunately, consumers remain cautious over worries about poor job prospects, falling housing values, and tight credit, while businesses remain on the sidelines due to uncertainty over future taxes, rising health care costs spurred by “ObamaCare,” new financial regulations still in the making, and weak demand from consumers.
The underlying key problem is that the de-leveraging process is not yet complete. Aggregate measures for household credit continue to fall; as of September 30th, total consumer indebtedness has fallen by nearly $1 trillion from its peak of $11.6 trillion, a decline of almost 8%. The values of outstanding mortgages have declined by 7.4% and home equity credit lines by 5.7% from their respective peaks (Exhibit 1).
Unfortunately, this contraction of credit is far from over: at the end of the third quarter, 11.1% of outstanding household debt ($1.3 trillion) was in some stage of delinquency. Credit is shrinking not only because of charge-offs; consumers also are now paying down their balances – a major change in behavior from a few years ago.
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Business credit also continues to deflate. Total credit on the books of commercial banks advanced to “business, commercial, and real estate” borrowers has declined from its mid-2008 peak of $5.2 trillion by roughly 15%. In the commercial paper market (large companies borrowing directly from credit markets thereby bypassing commercial banks), commercial paper outstanding has plunged from $2.2 trillion in the second quarter of 2007 to less than $1.1 trillion in recent months (Exhibit 2).
Since the economy “floats on a sea of credit,” it’s not surprising that the recovery is disappointing. What’s surprising is that the economy has grown as much as it has, given that credit is still contracting. (It’s only because of the large cash balances held in the corporate sector that allowed businesses to restock inventories, that we’ve had any recovery.) Financial crises are the result of asset bubbles, which in turn are driven by an expansion of credit. The recent bubble was made possible by “financial innovations” in the securitization of mortgages, resulting in an enormous expansion of credit. Now credit has to shrink as financial entities and consumers restructure their balance sheets.
Most economists expect this de-leveraging process to run a while longer before credit begins growing again. That means a slow recovery, at best. The Federal Reserve has pumped unprecedented amounts of money into credit markets, but the “velocity of money” has ebbed as the “demand for liquidity” soared. We arguably are in a text-book style “liquidity trap.” Commercial banks, for example, are sitting on some $1.2 trillion of cash reserves (normal is around $300 billion). Sometime, hopefully sooner than later, money will begin to move, credit will expand once again, and the pace of recovery will accelerate.
Meanwhile, Congress is facing gridlock on a number of policies that will affect the economy. The most important are the “Bush” tax cuts, which are scheduled to expire at the end of the year. Add to that, emergency unemployment insurance benefits (that will begin to expire at the end of November and will disappear by May 1), Medicare reimbursement rates for physicians, extension of the AMT fix that expired a year ago, and various tax credits such as Making Work Pay and other ARRA tax incentives set to expire at year end. If Congress is unable to act, it will cost the economy 1.5% of GDP growth in 2011 and 1.8% the following year, according to estimates from IHS Global Insight.
Yes, the federal budget deficit is monstrous and needs to be reduced -- just not right now! Raising taxes and reducing spending before the recovery is on solid footing would be a monstrous mistake. Exhibit 3 shows the budget gap; as a percent of gross domestic product (GDP), expenditures are at 25%, and revenues stand at record lows near 15%. The projections assume the President’s Deficit Commission revenue proposals are implemented (including elimination of ”tax expenditures, such as mortgage interest and real property tax deductions” as well as higher gasoline taxes).
Add Arizona’s Headwinds
On top of shrinking credit, Arizona is facing some unique challenges. The housing bubble, along with the effects of recent anti-immigration legislation, has burdened Arizona with an enormous inventory of vacant housing. Data compiled by the U.S. Department of Housing based on U. S. Postal Service surveys, shows nearly 130,000 vacant addresses in Arizona’s six metro areas. That’s a vacancy rate of 4.9%. Historically, vacancies have run in the neighborhood of 1.5%. Business vacancies stand at 12.2% (Exhibit 4).
This excess inventory of vacant homes needs to be significantly reduced before homebuilding resumes. Unfortunately, household formation has virtually disappeared. Mobility in this country remains at the lowest levels in at least 60 years, thanks to the credit squeeze and inability of home owners and buyers to sell their existing house (many are “upside-down”) and to obtain financing for a new one. In addition, the poor economy and high unemployment has forced households to double up.
Housing remains near the bottom by nearly any measure. After a boost early in the year from the homebuyer tax credit, residential permits have sunk to new lows. Only 13,000 units will be issued statewide this year, compared to over 91,000 in 2005. Existing home sales through multiple listing services (MLS) also have retreated in both large metros since tax credits expired. This was widely expected as payback for activity brought forward by tax incentives.
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Using realtor data, home prices have stabilized. After a few months of improvement earlier in the year, the median price of homes sold on the MLS leveled off in recent months and risk moving lower. Data from Standard and Poor’s Case Shiller also show the same results. Prices are nearing $140,000 in Tucson and $120,000 in metro Phoenix. The flood of foreclosures will continue to cap (or put downward pressure on) prices in the near term (Exhibit 5).
Recent Trends and Outlook
Nationwide, the manufacturing sector has been a bright spot, accounting for much of the progress during the recovery. Indicators such as exports, factory orders and industrial production have been trending upward. That hasn’t translated into jobs, however. In Arizona, manufacturing jobs have stopped falling, after declining by over 20% during the recession and by nearly a third over the past decade. The number of manufacturing jobs now is the lowest since early 1983!
Construction is the biggest loser, having shed 8,100 jobs during the past 12 months, followed closely by state and local non-education, down 6,100. Aerospace manufacturing (-3,300), wholesale trade (-2,600) and financial services (-2,200) also continue to decline.
From the end of 2009 through May, nonfarm employment was rebounding nicely, but since then, nearly all of the gain has been given back. Compared to a year ago, employment is little changed (Exhibit 7).
Measures of consumer spending also have given back earlier gains. Retail sales statewide have mirrored the path of employment – solid gains early in the year have been lost in recent months, so that seasonally adjusted sales in August were lower than the year earlier. Likewise, restaurant and bar sales have turned down although they remain above cycle lows. Airline passenger traffic at Sky Harbor and Tucson International also has given back portions of prior gains (Exhibit 8).
Recent trends are not encouraging. The possibility of a double dip cannot be ruled out at this juncture. So when will the recovery finally get on track?
We’ve had some encouraging news over the past year in solar and biotechnology industries, with several companies moving to or expanding in the state. So far, this hasn’t resulted in many new jobs, but it’s encouraging that industries with some growth potential are choosing Arizona.
For Arizona’s economy to accelerate, homebuilders need to get busy again. That won’t happen until inventories of vacant houses are reduced. And, with mobility at decades-low levels, that may be awhile. Mobility won’t recover until credit markets heal and the de-leveraging process comes to an end. Care to guess how much longer that will take? Keep your eye on credit flows, the key to the whole process. When credit begins expanding again, good things will start to happen.
We expect Arizona’s economy to improve modestly as we move into 2011. Population and employment will both grow at less than 2% annual rates. Personal income will eke out a very modest sub-four percent gain. Replacement buying will lift retail sales but consumers will continue to exercise their newly-found emphasis on thrift. The following year, 2012 will see the pace quicken but it will be 2013 before employment growth tops 100,000 and population growth approaches 170,000, levels that were common during the late 1990s (Exhibit 9).
Fortunately, there is not much risk to the downside, since homebuilding and allied industries have very little left to lose. This was not a typical, garden-variety, recession. The recovery so far is (and promises to remain) atypical as well.
For additional information, please contact the Economic and Business Research Center.
