The US economy

[David Smith]

A big current account deficit, high inflation and what some see as a housing bubble. Will 2006 be the year when the US economy comes down to earth, or can it carry on going from strength to strength?

[Ironman]

First, since it appears that I may just be the very first to take advantage of the new discussion forum, I would like to thank you for beginning your blog this year. As a US-based reader, I don't make a regular habit of UK-based newspapers and I wasn't familiar with your work until your blog appeared among Bill Parke's Economics Roundtable. Now, of course, I make a point of never missing it....

It seems to me that the first two items you note as challenges for the US economy are closely interlinked. Both have been highly driven by two factors: the devaluing of the US dollar, which has made products exported into the US much more expensive, and the high world demand for oil combined with hurricane damage to the US' oil production infrastructure. While the oil supply shortage (and corresponding links to the current account deficit and inflation) will be corrected as damaged facilities are repaired over time, the more serious concern will be whether the US will continue policies pursuing dollar devaluation. My guess is that the US dollar will stabilize this year, reducing the growth of both the current account deficit and inflation.

The housing bubble situation is another story - in the world of real estate, it's all about location, location and location. As it stands, where the housing bubble appears to have been greatest, it already appears to have ended (in the northeast and on the west coast). Meanwhile, high growth areas (such as the southwest) should continue to see continued growth in housing values, although at slower rates as interest rates have risen.

2006 should see economic growth in the US slow as other sectors of the economy begin picking up the slack as the recent boom in the US real estate market leaves off. With investors not having the single booming market of real estate in which to invest, look for more general growth in other sectors - particularly in manufacturing. For example, all those orders Boeing has taken this year will begin turning into dollars as those aircraft are built and delivered. This increase in production will have the benefit of also reducing the current account deficit, as the majority of these newly produced aircraft will be exported (remember, the dollar devaluation policy does benefit US manufacturing exports). As a result, I would expect that aerospace, which has been a huge, missing piece of the US economy for the last several years, will gain considerable strength in the next year.

[Guest]

[quote="Ironman"] the devaluing of the US dollar [quote]

On the contrary, I would argue that the US Dollar has been remarkably resilient and is currently way overvalued. Methinks that the last 9 months of 2006 will provide some real pressure, and don't entirely rule out a collapse.

[Ironman]

You are correct with respect to the US dollar's valuation. My impression of the US dollar's comparative value was based on its ongoing weakness at mid-year that I mistakenly assumed had continued to the present day, but it would seem that the other major world currencies have also been on a track toward greater weakness - hence the US dollar's greater strength and apparent resilience. By and large, it appears that the US dollar has stabilized in value sooner than I would have anticipated.

As for whether the US dollar is overvalued and poised to collapse - I think that scenario is unlikely - the second link above has a good discussion of the dynamics.

[David Smith]

John Makin's piece - your second link - is an excellent summary of the arguments against a dollar collapse. In the short-term relative growth rates determine currency values, in my view. That bodes well for the dollar against the euro and yen. The bigger question is whether there is an eventual diversification away from dollar holdings, by China, the OPEC countries and others. The problem for them is that this would be against their own economic interests, at least in the short-term, occasioning losses on their dollar assets. They may already be in too deep.

[sandid]

On the general topic of whether the US economy will avoid recession (as defined by GDP growth, or lack of) we can be sure of one thing, the US consumer will keep on spending more and more every quarter. US personal consumption expenditures have increased quarter on quarter every quarter since 1990 – right through the 1990/1991 and 2001 recessions.

What fell in the last two recessions was investment spending. Now, given the huge rise in US corporate profits since 2002 it would be very surprising if investment spending turns negative during 2006. It would really take a global shock to cut investment spending.

We can also count on government spending not decreasing significantly. So, unless the trade deficit really accelerates, continued growth seems assured.

But whether that will make the average American feel any better is another matter.

[ikitov]

There is no danger of recession in the USA the next five years.
Inflation (GDP deflator) will increase to 3-3.5% in the next two years.
There is a danger of deflation starting from 2010.
In 2006, unemployment will start to increase and reach 6% in 2008.

By the way, there was no recession in 2001. If you visit the BEA web-site you can get a updated (July 2005) version of the US GDP. Below is a short segment of the table around 2001.

q/q nominal real
1999q4 9,1 7,3
2000q1 4,7 1,0
2000q2 8,3 6,4
2000q3 1,6 -0,5
2000q4 3,8 2,1
2001q1 2,8 -0,5
2001q2 4,4 1,2
2001q3 0,2 -1,4
2001q4 3,6 1,6
2002q1 4,3 2,7
2002q2 3,7 2,2
2002q3 3,9 2,4
2002q4 2,4 0,2
2003q1 4,8 1,7
2003q2 4,8 3,7

Since 2003, when I started to study the US GDP, the value for 2001 jumped from -0.1 to 0.8. Other years between 2001 and 2004, however, were moved down by about 0.5% in average. So, it is hard to say what value for 2004 we will have in 2008.

[David Smith]

Interesting point about data revisions. It now looks, as you say, that the US neither had two consecutive quarters of declining GDP or, for that matter, negative year-on-year growth. I wonder what the Fed would have done if armed with these figures at the time?

[ikitov]

This is a big problem for me to cope with all these changes. I've made a prediction for 2004 and 2005 based on population approach. My model works very well for the last 30 years but not for the last two. It gives around 1% real GDP growth rate for 2001. (Thought was wrong.)
My 2003 prediction was about 3.2% for 2004 and 2.5% for 2005. Failed. After July 2005, however, I hope that further revisions will down somewhat higher official values.
Anyway, there is no problem for the USA in the near future. For the UK as well.

[sandid]

Interestingly, I checked the NBER site for the recession dates. But it took the NBER so long to declare the 2001 ‘recession’ over that I’m not sure they can cope with data revisions (although they have their own definition of a recession).

But these are bold predictions:

There is no danger of recession in the USA the next five years.
Inflation (GDP deflator) will increase to 3-3.5% in the next two years.
There is a danger of deflation starting from 2010.
In 2006, unemployment will start to increase and reach 6% in 2008.

They have dramatic implications.

If US unemployment rises to 6% in 2008, that gives Hillary Clinton a better chance in the presidential election. Therefore the Republicans will pick a fight with another country to make voters rally round the flag.

If inflation rises above 3%, interest rates will rise. Ben Bernanke will set an inflation target and raise rates because inflation is above target. The public will complain about the unemployment he’s creating but he’ll do it anyway and a right-wing government will back him because ‘that’s the rule’.

Both these predictions sound very believable to me. But how do they come from population studies? Doesn’t the number of illegal immigrants in the US make the size of the workforce even more unreliable that GDP data?

[ikitov]

I've just drafted a paper on labor force, inflation and unemployment in the USA. You can find it at my web-site. Briefly the findings are the following
•Inflation and real economic growth are independent and driven by different forces both related to population, however.
•The driving force for inflation in the USA is the labor force change. The inflation lags two years behind the labor force change.
•Unemployment is a lagged linear function of the labor force change and inflation with the lag times five and two years respectively.
•Stagflation and disinflation accompanied by decreasing unemployment are just natural results of the lag and the dependence of the inflation and unemployment on the labor force change.
•One can forecast inflation and unemployment two to five years ahead.
•The population projections constructed by the US Census Bureau provide a useful tool to evaluate the long-term behavior of the labor force changes. The current period of disinflation will probably transform into deflation starting 2010-2012.

There is no math or advanced economic theory in the paper, just simple comparison of the data available. This comparison provides a powerful tool for the predictions I have made.

[sandid]

Unfortunately, Adobe 7.0 said ‘The file is damaged and could not be repaired’ for http://www.ecokitov.narod.ru/paper_inflation.pdf

But the findings seem to imply that, if the driving force for inflation is labour force change, to control inflation you have to control employment – or at least control the growth in employment.

I think that’s what central banks are actually doing when they change interest rates. They can’t say they’re manipulating employment because that has political implications, but they’re doing it indirectly.

The great benefit for politicians in giving central banks control over interest rates is that it allows interest rates to rise (and employment growth to slow) without the voters being able to do anything about it. If there’s a lag between action and effect it makes it politically easier to take action.

I think the Paul Volker period in the US shows the link between inflation and employment. He took action over interest rates in a way the President or Congress could not have done.

The Commanding Heights interview with Paul Volker is here.

[ikitov]

I am afraid I have the same answer from my web-site. I am rerplacing the pdf file with a doc one. Probably it will make the trick. If not , I can send you a copy by e-mail.
I can not repeat all my findings and statements from the paper. But your guess is not right. The labor force change leads inflation by almost three years. SO, nobody controls current inflation, because its roots are in past. They we just lucky to have a long period (1990-2000 )of a constant labor force growth in the US. The period ended in 2000 and currently participation rate decays by 0.025 per year and working age popualtion change has a lo cal peak resulting in inflation growth during teh next three years. Then a drop will be observed. The decrease reaches its lowermost value in 2012, when the labor force change rate (here I mean only the working population change excluding participation rate change ) will drop from 0.01 per year to 0.002. The critical value for deflation is 0.003 as the last 40 years evidence.

[ikitov]

Some remarks about P. Volker.
As I mentioned above no current action can change past due to causality principle. P.Volker is not an exclusion. Inflation during his period just follows the way it is prescribed by the labor force change two-three years before. P.Volker made nothing to the observed inflation.
But, having my finding, one can start to think about the future deflation in the USA. It will be too late to try to overcome it with the same methods they apply now, i.e. interest rate.

[sandid]

That’s fair enough. Mervyn King is always keen to point out that any action the MPC takes is aimed at bringing inflation back on target in two years’ time.

But if you think deflation in the US will start when the labour force stops growing, that’s surprising. There will be a supply shock in 2012 rather than a demand shock, which the US hasn't seen before.

I would have thought a decreasing availability of more staff would push up wages and inflation – especially in service industries.