Brian Fallow on the economy

Brian Fallow is the Herald's Economics Editor

Brian Fallow: Economist downbeat on our third-biggest trading partner

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The economic forecasts the Reserve Bank released last week include the expectation New Zealand's trading partners will grow more strongly over the next three years than they managed during the boom that preceded the global financial crisis.

It is counting on growth in the world economy, and the Asia-Pacific region in particular, to help the economy recover once the immediate negative impact of last month's Christchurch earthquake subsides.

But the ink on the document was barely dry when Japan suffered a sickening blow.

It is our fourth largest trading partner and has only recently been overtaken by China as the world's second largest economy. At this point the damage to its economy and the region's can only be guessed at.

But what about the the largest economy of all, the United States? How does our third largest trading partner look? Forecasters expect it to grow between 3.5 and 4 per cent this year.

However, eminent American economist Professor Martin Feldstein, in a lecture at the Treasury this week, took a much more downbeat view.

If he had to pick a number it would be more like 2 per cent, he said.

As it has taken the US economy three years to get back to the level of activity it reached in December 2007, a cumulative 2 per cent including this year would not be much to show for four years.

The headwinds Feldstein sees the US economy battling this year are contractionary fiscal policy, oil prices, a "continuing disaster" in the housing market and an emerging one in commercial real estate.

The fiscal stimulus package adopted in the wake of the crisis was too small, Feldstein said, and it winds down this year, declining to US$130 billion from US$400 billion last year.

"It is so poorly designed it won't take a dollar-for-dollar US$270 billion bite out of GDP but even half of that is still nearly 1 per cent off GDP."

Meanwhile the new Congress is intent on cutting public spending and individual states have balanced budget requirements.

"So fiscal contraction will be a significant headwind to recovery."

Then there is oil. The US consumes about 7 billion barrels of the stuff a year so if the U$20 a barrel increase since the start of the year persisted for a year it would take the equivalent of another 1 per cent of US GDP out of the pockets of consumers and businesses.

The US imports more than 70 per cent of the oil it consumes. Some of that outflow of cash would come back to it, eventually, as higher exports to oil-exporting countries, but that would be offset by weaker demand in other countries, like New Zealand, where higher oil prices also act like a tax.

Another factor weighing on aggregate demand in the US is the state of its housing market.

In the last six months alone the fall in house prices was enough to wipe US$600 billion ($820 billion) off households' wealth, Feldstein said.

"It is being driven by defaults and foreclosures."

About 50 million American homes are owner-occupied with a mortgage and of them 5 million are in default or foreclosure. Around 28 per cent of home loans are "under water" - the borrower owes more than the property is worth. And not just slightly under water; the median loan-to-value ratio is 130 per cent, he said.

In many states mortgages are non-recourse loans. If the borrower defaults the holder of the mortgage can foreclose on the property and sell it, but cannot pursue the borrower beyond that for any shortfall.

Meanwhile commercial real estate presents its own set of issues.

Most of the lending in that sector is done by small local banks and not securitised. Loans are typically for five years so those made in 2006 are coming up for renewal. But real estate prices have fallen around 40 per cent in the interim and loans are usually for 80 per cent of the value.

The resulting losses will reduce the capital of the small banks and their ability to lend to the small businesses which have no access to capital markets or the big money-centre banks, Feldstein said.

Another risk he cited is the possibility of a sharp rise in real long-term interest rates.

They are abnormally and unsustainably low, at about half their long-run average, when they should be higher than average given rising US Government debt, nearly half of which is held abroad.

In addition the labour market remains weak. The unemployment rate is just under 9 per cent.

There are another 9 million Americans working short weeks and their employers are likely to move them back to full-time work before hiring more people.

And there are millions of discouraged job seekers who have withdrawn from the labour force.

For all these reasons Feldstein cautions against extrapolating from the pick-up in US consumer spending in the latter part of 2010.

For one thing, about half of that was spending on durables like cars, a proportion that is obviously not sustainable, he said.

And it was not based on a rise in incomes, but rather on a fall in the household savings rate which had risen strongly. He attributes that to the wealth effect from a 15 per cent rise in share prices, which added US$2.4 trillion to household wealth.

If households were willing to spend 4c in the dollar of that increased wealth, it would explain the increase in consumer spending.

The Federal Reserve's policy of quantitative easing was designed to engineer just that effect, by taking bonds off the table so that investors had to move into equities, Feldstein said.

But QEII only runs until the middle of this year. We cannot count on another 15 per cent rise in the US sharemarket.

With the most recent indicators recording falling industrial production and poor employment growth, the US does not look to have achieved a self-sustaining expansion.

- NZ Herald

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