Professor Paul Palley's
          Economics Seminars

It is understandable that many are looking at the years of 2000-2009 as being a particularly bad period for the American economy. Job creation was virtually nonexistent overall and many millions lost their job during the recession of 2007-2009. Compared to the strong job creation years of the 1990s, the recent decade looks even worse. Incomes stagnated for all but those in the upper 5%. Economic growth measured by real GDP was notably poor compared to other decades. What we see are patterns of explanation for this that emerge by looking at the data, but we also see what has been a relatively poor performance by the economy over the course of the last thirty years compared to the prior thirty years. What we also see is that underlying weaknesses in the economy have emerged over the course of this period that has increasingly taken hold, and only periodic bubbles in selected markets masked these trends. The technology and stock market bubble in the late 1990s at least did leave behind important new companies, communications infrastructure, and technology. The housing market bubble left in its wake little that can be considered to be positive. At the same time we have seen incomes stagnate and American workers feeling less confident in a globalized world that increasingly results in more competitive capital and labor markets.

Real Gross Domestic Product (GDP)

The data (the source is the Federal Reserve Bank of St. Louis) demonstrates the fact that the economy has generally performed worse since 1980 than it did during the prior thirty years. Real GDP grew at an average annual rate equal to 3.96% during the period of 1950-1979 versus an estimated 2.71% during the period of 1980-2009. This relatively weak result since 1980 occurred during a period when lower taxes and deregulation were argued to be the primary drivers of economic growth. It has at the same time been increasingly noted in the press that the percentage of GDP dedicated to forms of public investment was also much lower and educational attainment suffered greatly compared to other industrialized countries. This is true even as workers in the U.S. are facing an increasingly competitive world. For example, expenditures as a percentage of GDP on public infrastructure exceeded 3% from 1950 to 1970, but since 1980 it has been less than 2%. It is a fact that bottlenecks due to infrastructure limitations, whether they be at airports, on freeways, or at the ports, all decrease productivity. While this decline in public investment in the U.S. occurred, economies in Asia are rapidly modernizing.

Looking at data on a decade by decade basis further highlights the weaker results. The economy grew at an average annual rate of 4.17% during the 1950s, 4.44% in the 1960s, 3.26% during the 1970s, and then 3.05% in the 1980s, 3.19% in the 1990s, and in period of 2000-2009 the average rate of growth was an estimated 1.89%. This outcome for the last decade is very anemic. The period of the 1980s was also especially disappointing given the policy changes enacted. If we excluded the recession year of 1980 then the average rate of growth would be 3.42% for the period of 1981-1989. However, I have to note that as we would expect from a long period of very poor results from 1980-1982, the economy bounced back strongly in 1983 and 1984. This outcome would probably be anticipated regardless of fiscal policies. On balance then, the 1980s was also a disappointing decade.

Real Household Income

The graph above demonstrating trends in real household income (the source is U.S. Census Bureau) illustrates what many people clearly realize. We see that all groups to different degrees lost ground during the period of 2000-2008 (the results will be worse if data for 2009 was included), but we can also see that the distribution of income has changed significantly. Household incomes in the lowest 40% have not seen real gains in income over the course of the last forty years. Those in the third and fourth income groups, those at between the 40^th and 80^th percentiles (middle to upper middle class) saw their household incomes increase in the late 1980s and late 1990s, but as we can see the gains were marginal at best. What is clear is that the vast majority of the gains in household income since the middle of the 1980s were primarily confined to those in the top 5%. This significantly widened the distribution of income to levels not seen since the late 1920s before the Great Depression. In 1980 the top 5% earned approximately four time what those in the middle quintile earned, but by 2008 the ratio was nearly six to one. Over time, as the middle class saw its income growth stagnate, saving rates declined to nearly zero before the recession of 2007-2009 started, household debt increased significantly, and the stress associated with paying for necessities increased. As the stock market has performed exceptionally poorly during the later years analyzed here and the housing bubble burst (see below) wealth accumulated by the middle class has declined to exceptionally low levels given the future needs of this population as they approach retirement, and stagnate incomes indicate difficulty for future wealth accumulation.

The Stock Market

The real or inflation adjusted performance of the stock market as measured by the Standard and Poor’s 500 Index (the source is Yahoo! Finance) reflects important trends because the stock market indicates both the current and expected economic environment. The graph above demonstrates that while there were up and down years during the period of the 1950s and 1960s, the general direction was for real gains in the stock market, consistent with the relatively strong economic growth during this period. The 1970s were a period in which exceptionally high rates of inflation negatively impacted the stock market due to poor fiscal and monetary policies at the end of the 1960s and in the early years of the 1970s, and the oil crises that occurred. In fact the 1970s was a chaotic period economically, but the economy grew at a rate that was approximately equal to that of the 1980s and 1990s. What we see above then in the 1970s was the result of the impact of high rates of inflation and related uncertainty in the financial markets. Then starting in the early 1980s was a stronger stock market, but overall, adjusted for inflation, the market did not match its level of 1968 until 1991. What we also see after this was steady improvement until 1994, and then the stock market bubble occurred, and then a collapse. Another bubble associated with economic growth and financial speculation related to the housing market bubble led to another surge in stock market values until the financial crises of 2008. Indeed, the period of the 2000s was overall negative for investors. Given the details above related to the economy, it is not surprising that the stock has performed poorly in recent decades.

Contributing to the results described above was also efforts to deregulate the financial markets in the 1980s and 1990s, and then a series of subsequent financial crises since the late 1980s. The result is what has been called the “bubble” economies of the 1990s and 2000s. Overall, during the period of 1950-1979 the S&P 500 adjusted for inflation increased at an average rate equal to 3.92%. On the other hand, during the period of 1980 to 2009 the average real rate of return was 5.86%, but if you exclude the speculative bubble years of 1994-1999 when the return was 23.41%, then the return was only 2.35%. In other words, only the speculative stock market bubble years were a real net gain in those years versus the prior decades. As indicated above, the difference between the 1990s and 2000s is that the 1990s gave us significant investments in communications infrastructure and technology along with a series of important cutting edge companies, but the housing market bubble seems to have yielded little of value.

Home Prices

The Standard and Poor’s Case/Shiller price index clearly indicates trends that will not surprise anyone who owned, bought, or sold a home during the 2000s. Historically home prices have increased at a rate roughly equal to the inflation rate. As a result households tended to view the equity they owned in a home as a stable asset or source of wealth accumulation. Both low interest rates and free lending practices that were either supportable or not facilitated efforts to finance home purchases in the 2000s. The poor stock market (see the relevant section above) caused households and investors to seek alternate investment opportunities, and this also led to increases in investment in housing. Over time the speculative demand for housing increased beyond levels supported by economic fundamentals. Other factors were also at work, but poor regulatory practices, very loose monetary policies, and very poor corporate governance, and greed were the primary factors that led to the speculative bubble depicted above both nationally and in a bubble city like the Phoenix-area. If you bought a home in Phoenix prior to 2001 than you are now marginally ahead, but if you bought after this time than you are likely not. Those who own a home in some separate local markets in the Phoenix area faired better. The results nationally during this time horizon have faired better with the value of their homes. On the other hand, the diversion of funds from alternative investment opportunities to housing and related financial assets, and the subsequent financial crisis starting in 2008, has a terribly negative impact on the economy. In addition, seeing as massive of a decline in asset values as depicted above leads to long-term reductions in expectations and greatly weakens household consumption.

Interest Rates

Exiting the high inflation and interest rate environment of the 1970s and early 1980s, the data (the source is the Federal Reserve Bank of St. Louis) for key interest rates demonstrate a process of lower and lower rates. Low interest rates were the natural result of the lower inflation expectations that took hold due to effective monetary policies in the late 1970s to the late 1980s, the impact of globalization, and other structural adjustments in the economy. We see this in the pattern shown above for long-term interest rates like the 10-Year Treasury and Mortgage rates. On the other hand, there were two occasions when it can be argued that Federal Reserve policies were too loose. These periods followed the recessions of 1991 and 2001. This is illustrated in the top graph above in this section by the long period of time in which the Federal Funds rate was kept at relatively low levels. This policy decision was prompted by the slow recovery of the labor markets after the recession, but as we have seen above we were really in a long period of relatively weaker economic performance. Added to these low interest rates, and arguably much more important, was a very weak regulatory posture due to policies by politicians and the Federal Reserve. Cheap money combined with a weak regulatory stance does contribute to speculative bubbles like those described above. It is also not surprising that the combination of easy credit, low interest rates, and households constrained by meager income gains seeking to leverage what they do have will lead to an explosion of household debt.

Conclusion

The economy has changed greatly in recent decades. Globalization, the pervasive use of technology (especially communication technology), computing, and an increasing level of competition have all altered the economy positively and negatively depending on one’s point of view. On balance, we have seen a rapid advancement in technology that is positive. Increasing productivity and competition were important factors contributing to the lower inflation and interest rate environment. Globalization leads to great connectivity among economies, and in the long-run this should be positive. Yet, in many ways the U.S. economy has underperformed for the vast majority of the population. As I indicated above, economic growth in recent decades has lagged behind trends associated with the thirty years starting in 1950. Incomes have stagnated for most of the population, and income inequality has grown to levels not seen since the 1920s. The stock market and housing market created speculative bubbles facilitated in part by investors divorcing themselves from economic fundamentals and deregulation combined with very poor corporate governance. These problems all call for the identification of solutions. Economists will turn to the efforts that increase productivity and competitiveness when identifying solutions. These include increasing investment in education, research and development, and infrastructure. In addition, in order to facilitate efforts by the public to adapt to the changing economic environment, institutions and programs that promote geographic and employment mobility are important.

The Economic Stimulus Act of 2008 included tax rebates that were supposed to help with the effort to jump start the economy. Debate related to the relative effects of government spending versus tax cuts was reignited in the press as the act was designed and then passed. This report (see link included below) completed by the Federal Reserve indicates that only one-fifth of those surveyed significantly increased their spending due to the rebate. More than one-half of those surveyed used the money to primarily pay off debt. The evidence is that only one-third of the rebate was spent (this is much lower than hoped for). The results further explain why short-term increases in government spending has a much greater positive impact on the economy than tax rebates when the economy is in recession.

The link is: http://www.federalreserve.gov/pubs/feds/2009/200945/200945pap.pdf

Uncertainty related to the current and future strength of the economy following the deepest recession since the Great Depression results in people looking to experts for forecasts. The Great Recession is technically over, but uncertainty prevails. The National Association for Business Economics (NABE) is an excellent source of economic forecasts. The November 2009 NABE Outlook (see: http://www.nabe.com/) indicated an improved outlook for 2010, and that companies should start adding jobs soon. NABE also indicated continued slow growth in household spending, but business investment and corporate profits are more positive indicators. The dollar will weaken marginally, and housing starts will improve significantly but remain well below long-term trends associated with normal economic conditions. The consensus is that inflation rate will remain low due to the relatively weak economy as illustrated by the expectation that the unemployment rate will remain high by historical standards, and the Federal Reserve is not expected to start tightening until next spring. The forecast represents the consensus of macroeconomic forecasts that have been prepared by a panel of 48 professional forecasters.

Real GDP declined at an annual rate of 1.9% during 2008. Then there was a severe decline in real GDP at an annual rate in excess of 5.0% during the first quarter of 2009. This is the worst result for the economy in fifty years. Overall, it is expected that real GDP will decline 0.2% in 2009, and then show improved economic growth equal to 3.2% in 2010. This reflects relatively weak increases consumer spending. As indicated above, improvements in business investment, especially in inventories and to a lesser extent in equipment and software, are expected. The very weak housing market and the significant decline in wealth due to declining home values are the primary reasons for continued weakness in personal consumption expenditures. The consumer price index is expected to decline 0.3% in 2009 due to weakness in the economy and the labor market, but this deflation should not continue into 2010 as it is expected the inflation rate will equal 1.8% in 2010. Improved stability in the credit markets and the very robust rally in the stock market are positive indicators. Significantly below trend levels of housing starts and home prices will occur in 2009. Only 580,000 housing starts are expected in 2009, and only 790,000 are expected for 2010. The majority of analysts believe the housing market has bottomed, but a slow recovery is expected.

The absence of inflationary pressures allows the Federal Reserve to pursue very aggressive monetary policies. The consensus of the economists who were surveyed by NABE is that the Federal Reserve will leave the federal funds rate target this year at nearly 0.0%, but that it will raise it to the still very low rate of 1.00% by the end of 2010. The expectation is also that long-term interest rates will also remain relatively low. The yield on the 10-year Treasury note is expected to equal 3.50% at the end of 2009 and increase to 4.15% by year-end 2010 reflecting the expected improvement in the economy. These relatively low long-term interest rates, party the result of aggressive monetary policies, will contribute to low mortgage rates.

The strength of the dollar is important to those who are interested in traveling and those who import and export goods and services. The dollar strengthened when the financial markets crisis deepened during the second half of 2008 as global economic weakness led investors to purchase dollar denominated assets to try to hedge against risk. One Euro bought 1.58 dollars in July 2008, but bought only 1.32 dollars in January 2009. Since then, improvements in the stability of the global economy led to a resumption of weakness in the dollar. The economists expect the dollar to continue to be relatively weak in 2009 and 2010. One Euro is expected to be able to buy 1.48 dollars in 2009 and 1.47 dollars in 2010. Reflecting the expectation that the economy will start to strengthen later in 2009, the S&P 500 Index is expected to end 2009 at 1095 and end 2010 at 1199.

There are other very good resources on the internet for forecasts related to the economy and specific economic indicators. Among the good resources include websites for the Congressional Budget Office (http://www.cbo.gov/), The Federal Reserve Bank of Philadelphia’s Livingston Survey (http://www.philadelphiafed.org/research-and-data/real-time-center/livingston-survey/), Mortgage Bankers Association (http://www.mbaa.org/), National Association Home Builders (http://www.nahb.org/), and Freddie Mac (http://www.freddiemac.com/).

There are differences between the short-run and long-run that have real implications for the productivity of a business’ inputs and the cost of doing business. In order to understand this concept it is important to clarify a few definitions and concepts. Then, understanding these points allows for an appreciation of why a business makes decisions at different points of time related to their workforce and capital. To start, labor encompasses the work force. The capital items owned by a business include plant facilities and equipment. This could include computers and other technology, distribution centers, factories, machines, and many other capital items. In fact, it is the desire by businesses to keep up technological trends that trigger many of the changes to capital most prominently monitored by the press and the public.

The difference between the short-run and long-run is not defined by a set point of time. Instead, the short-run is a period of time in which the composition and amount employed of one of the inputs used in the production process, usually capital, is fixed. On the other hand, in the long-run the composition and amount employed of one of the inputs used in the production process, usually labor, is variable. How long the short-run lasts depends to a great extent on the particular business or industry. For example, restaurants may make investments in new dining fixtures or kitchen equipment every few months as they adapt to new demands from customers, or due to changes the competition makes, or variations in their menu. As a result, the short-run in this case lasts only a few months. On the other hand, Intel spends two or three billion dollars on their factories and retools them only every two or three years. As a result, their short-run lasts two or three years.

Another important concept to consider when comparing the issues businesses deal with evaluating decision-making in the short-run and long-run is the law of diminishing returns. The concept is that as firms add additional units of their variable input to their fixed inputs in the short-run, after some point, the increment to total output will decline. In other words, productivity diminishes. This limitation to productivity demands innovation and investment in order to increase productivity and lower both average and marginal costs. Once a decision is made to alter your productive inputs then we are clearly now reflecting the difference between short-run rigidity and the long-run which permits opportunities for various combinations of inputs and new capital and labor opportunities.

As a result, the fact that the long-run is a period where all inputs are variable indicates that the firm can vary its inputs and make capital investments in order to find the lowest cost way of doing business. Due to this, average and marginal costs will always be lower in the long-run than the short-run. The firm will invest in new software or computer equipment, the factory, a printing press, new robotic equipment, or other capital items because of the increasing productivity and lower costs that result. The smart firms do this proactively as they search for opportunities for continuous improvement and a competitive advantage.

Here are some interesting resources to read about technology on a day by day basis. The Wall Street Journal is a very good resource for daily business news, and it includes a Tech section that is updated throughout the day (see http://online.wsj.com/public/page/news-tech-technology.html). The New York Times also includes a Technology section in their online addition that can be monitored each day (see http://www.nytimes.com/pages/technology/index.html). Both the Wall Street Journal and the New York Times offer good Blogs as well. Google offers an online Sci/Tech link that aggregates news related to science and technology and may serve as a good starting place for you daily reading (see http://news.google.com/news/section?pz=1&cf=all&ned=us&topic=t&ict=ln). Have fun with identifying other good resources that will be interesting to review as you monitor trends related to technology.

Here is an excellent article to read about the aftermath of financial crises, and their impact. Given the crisis of 2008, it is very instructive. The link for the article is: http://www.economics.harvard.edu/files/faculty/51_Aftermath.pdf

This update reflects the most recent data related to the indicators of measures of risk that are evident in the financial markets and are discussed below. These measures of risk are useful for monitoring the perceptions of investors related to the stability of the economy both today and in the future. As a result, these indicators are useful for producing forecasts. The following discussion focuses on historical data related to the 3-Month Treasury bill rate, the three-month Libor rate, the 10-Year Treasury Constant Maturity rate, inflation expectations, Moody’s Seasoned Aaa Corporate Bond Yield, and the value of the dollar. What the discussion below indicates is that the markets expect the U.S. and global economy to strengthen, that the extraordinary measures used by the Federal Reserve and other central banks to stabilize the markets are still in place, and that there are also signs that the worst of the financial crisis is perceived to be behind us. It is clear that both the supply of money in the financial system has increased and that at the same time perceptions of risk have declined some. At the same time, we are some distance away from what we would normally consider to be normal levels of stable economic growth. Risks that are being focused on still include the underlying strength of the slow recovery of the housing market, the very poor commercial real estate market, the basis for surges in commodity prices (especially oil and gold), outstanding and unrecognized debt crises, and the political will to continue to facilitate economic growth.

The 3-Month Treasury bill: Secondary Market Rate is an indicator of economic stress because investors look for the safest places to invest their money during a crisis, and the safest investment is the 3-Month Treasury bill. When looking at historical data, it is clear that a 3-month Treasury bill rate in the range of 3.00% and 4.00% is associated with a healthy and stable economy with low levels of inflation. Higher rates reflect higher inflation expectations and a 3-month Treasury bill rate in the range of 2.00% and 3.00% reflects much lower inflation expectations, and slower expected economic growth. We can see in the graph below that first in March 2008, and then in September 2008, October 2008 and November 2008, there were precipitous drops in the 3-month Treasury bill rate. Seeing the 3-month Treasury bill rate approach 0.00% is a sign of extreme financial distress in the financial markets, and the extraordinary lower rates since November 2008 indicate persistent weakness and uncertainty. More recently, these very low rates are also due to very aggressive Federal Reserve policies designed to increase liquidity in the financial markets and reserves in the banking system. We should expect these rates to remain extraordinarily low as long as investors continue to perceive significant risks confronting the economy, and the financial services industry remains in a weakened state and in a risk-averse mood. At the same time, the size of excess reserves held by the banking system and low 3-month Treasury bill rates indicate a large volume of cash on the sidelines that can be employed more productively once confidence increases.

The three-month Libor is the rate that banks pay each other to borrow for three months. The graph below shows that it rose significantly in the month of October 2008, reflecting the perspective of banks that there was significantly greater risk related to lending to one another. Credit was choked off during this credit crunch, and lending between banks declined dramatically, contributing to the severity of the recent recession and a reduction in credit available to businesses and households. This decline in this rate reflects the exceptional amount of monetary stimulus undertaken by the Bank of England and other actions by the British government, and central banks around the world. In other words, the significant decline in the three-month Libor starting in late October 2008 was not a sign of a healthier economy. What this indicates was the need for extreme actions by monetary authorities to rescue the financial markets and economy. Instead, a healthy economy is one where the three-month Libor fairly reflects the risks associated with a stable economy. In recent years this reflected by the three-month Libor being in the range of 4.00% and 5.00%.

The 10-Year Treasury Constant Maturity Rate is an important indicator in that many other long-term lending rates are tied to it either explicitly or implicitly. Mortgage rates, for example move in the same direction as the 10-Year Treasury rate as they represent alternative forms of long-term investment. The difference between the two rates indicates the risk associated with mortgages. The sizeable decline in as the 10-Year Treasury rate starting in March 2008 reflected the rush to quality or risk-free investments that accompanied the decline in the financial markets. Rates increased after that point, but then a significant decline occurred at the end of 2008 as investors fled to safe investments. The 10-Year Treasury rate has stabilized at lower levels in the range of 3.00% to 3.75%. This indicates an improvement, but a 10-Year Treasury rate at these low levels indicate a very weak economy as this can only be the result of exceptionally low inflation expectations or continued investment in U.S. Treasuries versus riskier investments indicative of confidence in the economy. A healthy economy with inflation expectations in the range of 2.00% to 3.00% would indicate a 10-Year Treasury rate in the range of 5.00% to 6.00%.

The difference between the 10-Year Treasury Constant Maturity rate and the 10-Year Treasury Inflation-Indexed Security is a very good measure of inflation expectations. Inflation is not necessarily a bad thing at all because it is associated with growing economies. On the other hand, the exceptionally high rates of inflation seen in the 1970s significantly stressed the economy. Very low rates of inflation can also be a real problem because this indicates lower rates of economic growth which limits the ability of businesses to raise the prices of their products, and this reduces the profits they then earn. Deflation is a far more significant risk as declining prices lead to lower profits and potentially losses due to serious declines in all forms of spending. The reason is that buyers wait for even lower prices. Deflation is associated with severe economic recessions and depressions. The sporadic increases in inflation expectations between the middle of 2006 and the middle of 2008 depicted in the graph below reflected higher commodities prices and other inflation pressures. The decline in inflation expectations to nearly 0.00% after that point as shown in the graph below indicates severe economic distress and the expectation that the economy will continue to be very weak, and that deflation is a threat. The increase in inflation expectations to just over 2.00% more recently is a moderately positive sign because it indicates that deflation is less of a risk, and that some economic growth is expected in the future. In general, it is believed that inflation rates in the range of 2.00% and 3.00% are associated with a moderately growing and stable economy.

Moody’s Seasoned Aaa Corporate Bond Yield is an indicator that tells us something about the availability of funds for businesses seeking to raise money, and as a result perceptions of risk facing corporations. Notice in the graph presented below that the real, inflation adjusted, Moody’s Seasoned Aaa Corporate Yield rose sharply between September and November 2008. This is the same period in which, as noted above, the 3-month Treasury bill rate approached 0%. As I also indicated above, this indicates a flight to risk free assets, and even away from even the safest corporate bonds. This is a sign that financial markets perceived significant risks to the real economy, and suggests that if these conditions persisted then the most credit worthy borrowers would face real issues related to their financing efforts. Bond issuers that are associated with higher levels of risk saw even more significant increases in the yield on their bonds. The decline in the real, inflation adjusted, Moody’s Seasoned Aaa Corporate Yield since January 2009 is a positive sign because it indicates an increase in the supply of funds for the least risky borrowers and also indicates the perception that economic conditions are improving.

The Trade Weighted Exchange Index for the value of the dollar versus major currencies is another important indicator related to the perceived risk associated with the global economy. The dollar is generally considered to be a safe haven currency, and as a result in times of global economic stress we will see investors buying dollars that they can use to purchase U.S. Treasury bills and other dollar denominated investments. The long-term trend for the dollar is that it is declining in value. The reason for this is the sizeable trade deficit carried by the U.S. What we can see in the graph below is that the dollar increased in value during the last half of 2008, followed by a brief decline, and then once again a sizeable increase between January and March 2009. Following this, the dollar resumed its decline in value. These increases in value were directly the result of the financial crisis which had become a global financial crisis. What we see though, is that the dollar is resuming the long-term trend that has been in place since the early 1980s. Contributing to the decline in value is also increases in demand for oil and gold, commodities that are alternatives for those worried about inflation or risk. These increases in the value of these commodities are also the result of the exceptionally low interest rates today as this facilitates investing in commodities on margin. As the economy stabilizes further interest rates will increase and the prices of these commodities will correct and the decline in the value of the dollar will be more gradual.