The Economy: When Will Happy Days Be Here Again?Published: June 08, 2011 in Knowledge@Wharton
The latest economic reports show the U.S. recovery has faltered. But someday, surely, there will be a real recovery. What forces will drive that upturn? And will the healthy economy of the future look different from those of the past -- establishing a "new normal?"
Two intertwined factors are critical to any rebound, according to many experts: Home prices must stop declining and begin to rise, and consumers must spend more freely. In addition, exports must continue to grow and businesses and consumers must feel the government is making significant progress in resolving its deficit problems and clearing away regulatory uncertainty. Government efforts like stimulus spending and keeping interest rates low are not expected to be key factors in a recovery.
Given the many problems afflicting the economy, a vibrant recovery could be years away. The economy grew at an anemic 1.8% annual rate in the first quarter, down from 3.1% in the fourth quarter of 2010. On Tuesday, Federal Reserve chairman Ben Bernanke offered little optimism for the immediate future, calling the recovery "uneven" and acknowledging that it is unlikely that the central bank can solve the economy's woes by itself.
"It's too soon to be talking about a return to a healthy economy; there is a long mid-range period in our future," says Susan M. Wachter, a Wharton real estate professor, adding: "We are three, four, five years away from being back to what might be considered the 'new normal.'" The key obstacle, she notes, is the real estate market -- commercial and residential. "Construction is a job-intensive industry. It's usually the sector, in terms of employment, that leads the job recovery, and that's missing in action this time around. It makes the overall recovery far more vulnerable to other negatives."
To have a vibrant recovery and economic expansion, housing has to go from "being a headwind to a tailwind," according to Mark Zandi, chief economist and cofounder of Moody's Economy.com. "It's hard to get enthusiastic about the economy with house prices falling," adds Wharton emeritus finance professor Marshall E. Blume. "The consumer has to feel that the economy is on the right track, and there are not many headlines saying it is on the right track right now. The consumer hears this and says, 'I've got to be careful.'" With inflation taken into account, consumer spending has been virtually flat in recent months, and surveys show consumer confidence sagging.
Consumers, who traditionally account for about 70% of economic activity in the U.S., have a number of legitimate worries. While layoffs have abated somewhat, many employers are limping along, leaving workers to worry that they could be out on the street if the conditions get worse instead of better. On June 3, the Labor Department reported that only 54,000 jobs had been created in May, compared to about 220,000 in each of the preceding three months. Also, despite a dramatic surge in the past two years, the stock market remains below its past peaks, and gains for the past decade are very meager. Many people feel poorer than they were four or five years ago, especially when they consider what their 401(k)s and other investments would be worth today had there been no financial crisis, and returns had continued at an historical rate.
While a real estate rebound and surge in consumer spending are essential to a recovery, other factors can play a role, says Zandi. There must be solid growth in emerging markets to drive U.S. exports, and it will help if the dollar falls in relation to emerging market currencies like the Chinese yuan, making American goods cheaper for foreigners. Also, he adds, U.S. businesses will have to spend more on workers and expansion -- but that will not happen until they are confident that the country's fiscal problems and regulatory uncertainties are being resolved.
Even if all other factors do improve, a robust recovery seems unlikely if the real estate market doesn't get substantially stronger. The Standard & Poor's Case-Shiller Home Price Index, measuring 20 major metropolitan areas, seemed to hit bottom in March of 2009, then began a slow rise. But it reversed course last July and has since declined to new lows. Sales of existing homes are running at an annualized rate of about five million, down from seven million in 2005, despite a population increase and home-price declines. "Clearly, the housing market has to stabilize, and it looks like it's almost in a falling condition again," notes Blume. "Since housing is a major component of many households' balance sheets, many households don't feel wealthy."
The average home is worth about 30% less than it was before the crisis, and nearly 25% of households with mortgages find they owe more than their homes are worth. (About two-thirds of homeowners have mortgages.) Being "underwater" often makes it impossible to move for another job. A few years ago, millions of homeowners refinanced or took out second mortgages to convert home equity into spending money. That's not possible when there is no home equity left, and about 40% of those who took out second mortgages are now underwater. Even people who have good jobs and plenty of money will often restrict spending when falling home values make them feel poorer.
In large part, low home prices are due to excess supply, caused by millions of foreclosures and other "distressed" sales dumping properties on the market at fire-sale prices, says Wachter. "One glimmer of hope is that the pace of foreclosures has slowed," she notes, adding that it could take some time for home prices to stop dropping. "The spring of 2011, when we were supposed to see a housing recovery, has been postponed."
With the excess of supply and low prices, there is diminished need for new homes, and construction has dropped from about one million units a year in a healthy economy to about 500,000, according to Wachter. Commercial construction has also slackened. In the six recessions prior to the latest one, construction has been a key factor in the recovery, Wachter points out. Construction employment typically rises by more than 30% in the two years after a recession ends; in the two years since the end of the latest recession, however, construction jobs have fallen an additional 10%. "That is historically unprecedented," she says.
The New Magic Number
What will it take for the housing market to turn around?
Much of the home-price decline of the past few years is a reversal of the price bubble that preceded it, when easy money allowed buyers to pay far more than properties were worth by any reasonable standard. Nationwide, prices are now about where they were in 2002, before the worst of the bubble, suggesting that much of the excess has been worked off. By many standards, such as the ratio between home prices and household incomes, homes in much of the country are now selling at bargain prices.
But there is an additional problem: downward pressure on prices from the excess supply of homes for sale due to foreclosures on homeowners who have defaulted on their loans. Defaults are no longer centered on subprime borrowers who probably should not have been given loans in the first place. Now, people who had seemed to be sound credit risks are defaulting as well. And it's no longer just the toxic adjustable-rate loans with big payment increases that are failing: People are defaulting on standard 30-year, fixed-rate mortgages, too. The high unemployment rate is a key factor.
Federal programs have failed to keep as many troubled borrowers in their homes as the government had hoped, often because homeowners who do receive payment reductions later default anyway. Given all the problems in real estate, Wachter doesn't expect any significant improvement in construction before the end of 2013, indicating the new normal for housing and the economy will not appear until 2016 or 2017.
But even if the housing market stabilizes, there is no guarantee that the other key to recovery -- consumer spending -- will follow suit, since consumer behavior is hard to predict. Clearly, people spend less when they have immediate money concerns. Those fears will ease if layoffs shrink and employers hire more workers. And any period of weak consumer spending is followed by a release of pent-up demand for appliances, cars and other necessities, so consumers can be expected to loosen purse strings somewhat if they begin to feel more secure.
In the past, consumers have often purchased non-necessities like vacations, bigger homes than they need and new cars to replace old ones that still work well, but there's no guarantee they will resume these habits when money is available. For many consumers, the shock of the past few years may have been a wake-up call, a notice that they were actually spending too much back in the good years. It has long been clear to financial experts that most people have been saving too little for retirement; this may now be apparent to larger numbers of consumers as well. A new frugality could slow the economic recovery, Wharton faculty and other analysts suggest.
That begs the question: Will the definition of a healthy economy be different in the future than in the past? Some experts think the unemployment rate, now over 9%, may not fall to the levels previously considered "healthy" -- around 5%. "I would not disagree that unemployment levels may increase from what they were in the past," notes Blume, referring to rates considered "normal." "We do have, in my judgment, a structural unemployment problem -- people who do not have the education or the skills to participate in this advanced economy."
The most secure workers, Blume says, will be those with jobs that cannot be exported. That will include unskilled jobs like mowing lawns, as well as highly skilled jobs that must be done locally or for which foreign workers are not equipped. But any job that can be done just as well overseas will be threatened, according to Blume. Gradually, that will include jobs like editing, analyzing x-rays, preparing financial reports, even performing legal services -- anything that can be done remotely with a computer and Internet link. Offshore call centers are just the beginning. Many U.S. workers will simply not be prepared to compete in this environment, causing the unemployment rate to rise, Blume predicts.
"It's not just the lowest-paid people who will have these problems," he says. Currently, Blume notes, surgeons have to be in the operating room, but that may not always be the case. "Ultimately, there has to be an equalization of wage rates for occupations of the same skills across the globe."
Zandi agrees that the "normal" unemployment will probably rise. "Before the recession, it was 5%. Post-recession, it's probably going to be closer to 6%." Other economists think it could be higher.
It is not that the recession changed the economy, says Wharton finance professor Richard Marston. In fact, the economy has been changing for decades, but in recent years the effects were masked by the housing bubble, which temporarily supplied lots of low and semi-skilled jobs in construction, real estate sales and mortgage origination.
"The long-run trend is toward higher productivity and towards an increasing need for skill and education," Marston states, noting that while overall unemployment is around 9%, the figure is just 4.5% for college graduates and 14.6% for workers who didn't finish high school. In manufacturing, he adds, production has doubled since 1980 while employment has fallen from 18.7 million to 11.5 million due to productivity improvements like computers and assembly line robots.
The future may also produce a different housing profile. In 2004, the U.S. hit its peak in home ownership, with about 69% of households owning rather than renting. Currently, the figure is around 64% and likely will fall two or three points lower, to a level consistent with most of the post-World War II era, Wachter predicts. But there is some danger that the new normal could be even lower, she adds. That would mean a significantly higher portion of the population would be subject to the uncertainties of rent increases -- and cut off from the long-term financial benefits of ownership, a key to getting into the middle class and staying there.
Already, tighter lending standards like the 20% down payment requirement make it very hard for people in their 20s to buy their first homes, she notes. Much will depend, she says, on what the new mortgage market looks like if the government phases out Fannie Mae and Freddie Mac, which have long supported low-down payment loans. "It's already an issue because we're locking people out" of the housing market, she says, adding that for many people, the vision of a nice house in the suburbs may never be realized, though they might have achieved that in the past.
While the government has worked to keep interest rates low and engaged in massive spending to stimulate the economy, none of those interviewed said new efforts of this type would be the key to an eventual recovery. For one thing, additional spending is now politically unpalatable. In addition, Marston notes, policies to stimulate by reducing interest rates traditionally work by boosting the real estate industry. "This time, we have a huge overhang of both residential and commercial real estate. As a result, we are getting no push from real estate and therefore no surge in real estate-related jobs. That is true despite record low interest rates. In this setting, further monetary stimulus is ineffective at best.
"We have to rely on the private sector to increase its demand for workers," Marston adds. "I believe employment will gradually improve, but I must admit that the process is disturbingly slow."
In Washington, lawmakers are wrangling over future tax policy, the deficit, spending priorities and programs like Medicare. That much uncertainty does not contribute to economic stability. "We're coming [up on] an election year," Blume says. "I daresay the politicians won't make things clearer." He notes that Republican candidates are sure to keep consumers focused on economic worries that have persisted under a Democratic president.
Many businesses will be reluctant to place bets on the future until they see the raft of regulations to be written under last year's Dodd-Frank Wall Street Reform and Consumer Protection Act. Regulation writing is taking longer than expected, Blume points out. Other countries and international regulators are also reworking rules that affect business and financial markets, making it even harder for businesses to place their bets on the future. "There's a lot of regulatory overhang in Washington right now, which could cause businesses to delay investments, and cause consumers to delay purchases," Blume says. "Until that overhang is cleared, we may not have fat growth."