Gloom returns to US just as all seemed fine

The near-term economic outlook is weak at best. A projected recovery in consumer spending did not occur and a third of homeowners are in negative equity. Martin Feldstein writes.

NEW YORK, NY - JUNE 27: People walk through a mall on June 27, 2011 in New York City. The Commerce Department reported that American consumer spending was unchanged from April to May for the first time in a year. Spending dropped 0.1 percent in April when adjusted for inflation, the first two-month decline since April 2009. Spencer Platt/Getty Images/AFP== FOR NEWSPAPERS, INTERNET, TELCOS & TELEVISION USE ONLY == *** Local Caption *** 307589-01-09.jpgShow less

The American economy has slowed dramatically, and the probability of another economic downturn increases with each new round of data.

This is a sharp change from the economic situation at the end of last year and represents a return to the very weak pace of expansion since the recovery began in the summer of 2009.

Economic growth in the US during the first three quarters of last year was not only slow, but was also dominated by inventory accumulation rather than sales to consumers or other forms of final sales.

The last quarter of the year brought a welcome change, with consumer spending rising at a 4 per cent annual rate, enough to increase total real GDP by 3.1 per cent from the third quarter to the fourth.

The economy seemed to have escaped its dependence on inventory accumulation.

This favourable performance led private forecasters and government officials to predict continued strong growth this year, with higher production, employment and incomes leading to further increases in consumer spending and a self-sustaining recovery.

A one-year cut of the payroll tax rate by 2 percentage points was enacted to lock in this favourable outlook.

Unfortunately, the projected recovery in consumer spending did not occur. The rise in food and energy prices outpaced the gain in nominal wages, causing real average weekly earnings to decline in January, while the continued fall in home prices reduced wealth for the majority of households.

As a result, real personal consumer expenditures rose at an annual rate of just about 1 per cent in January, down from the previous quarter's 4 per cent increase.

That pattern of rising prices and declining real earnings repeated itself in February and March, with a sharp rise in the consumer price index causing real average weekly earnings to decline at an annual rate of more than 5 per cent. Not surprisingly, survey measures of consumer sentiment fell sharply and consumer spending remained almost flat from month to month.

The fall in house prices pushed down sales of both new and existing homes. That, in turn, caused a dramatic decline in the volume of housing starts and construction. That decline is likely to continue, because nearly 30 per cent of homes with mortgages are worth less than the value of the mortgage.

This creates a strong incentive to default, because mortgages in the US are effectively non-recourse loans: the creditor may take the property if the borrower does not pay, but cannot take other assets or a portion of wage income. As a result, a tenth of mortgages are now in default or foreclosure, creating an overhang of properties that will have to be sold at declining prices.

Businesses have responded negatively to the weakness of household demand, with indexes maintained by the Institute for Supply Management falling for both manufacturing and service firms.

Although large companies continue to have very substantial cash on their balance sheets, their cash flow from current operations fell in the first quarter. The most recent measure of orders for non-defence capital goods signalled a decline in business investment.

The pattern of weakness accelerated in April and May. The relatively rapid rise in payroll employment that occurred in the first four months of the year came to a halt in May, when only 54,000 jobs were created, less than a third of the average for employment growth in the first four months.

As a result, the unemployment rate rose to 9.1 per cent of the labour force.

The bond market and share prices have responded to all of this bad news in a predictable fashion. The interest rate on 10-year government bonds fell to 3 per cent, and the stock market declined for six weeks in a row, the longest bearish stretch since 2002, with a cumulative fall in share prices of more than 6 per cent. Lower share prices will now have negative effects on consumer spending and business investment.

Monetary and fiscal policies cannot be expected to turn this situation around. The Federal Reserve will maintain its policy of keeping the overnight interest rate at near zero. Moreover, fiscal policy will actually be contractionary in the months ahead.

The fiscal-stimulus programme enacted in 2009 is coming to an end, with stimulus spending declining from US$400 billion (Dh1.46 trillion) last year to only $137bn this year. And negotiations are under way to cut spending more and raise taxes to reduce further the fiscal deficits projected for this year and later years.

So the near-term outlook for the US economy is weak at best.

Fundamental policy changes will probably have to wait until after the presidential and congressional elections in November next year.

Martin Feldstein, professor of economics at Harvard University, was the chairman of Ronald Reagan's Council of Economic Advisers and is also a former president of the National Bureau for Economic Research

* Project Syndicate