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Fed and Treasury Chiefs Fiddle as Economy Plummets

by PETER MORICI

On Friday, the Labor Department reported the economy lost 63,000 payroll jobs in February, after losing 22,000 jobs in January.

Governments added 38,000 jobs and private sector employment contracted 101,000. Businesses have become too pessimistic about the outlook for the economy, and the capacity of the Bush Administration and Federal Reserve to manage it, to be adding new employees or replacing those that leave.

The Labor Department reported a slight decrease in the unemployment rate to 4.8 percent. However, this statistic was greatly affected by the fact that so many adults have become discouraged and have stopped looking for work. Factoring in the decline in the number of adults participating in the labor force, the unemployment rate is closer to 6.8 percent.

These poor jobs data are the strongest evidence yet that the economic expansion has ended. The economy has slipped into a recession of uncertain depth and duration.

Weak retail sales and slow automobile sales indicate high gasoline prices and the subprime crisis have slowed down consumers. Along with weakness in housing and nonresidential construction, weak retail and automobile sales are causing businesses to trim second quarter production, investments in new capacity, and hiring plans.

Exports are lifting sales and employment in durable goods and materials industries that support those industries, but overall a weaker dollar against the euro and other currencies and the resulting increase in exports are not enough to lift industrial production and employment from recession levels.

Contribution of Federal Reserve Policy

Rising prices for food, energy, metals, and other materials are pushing up inflation, but the Federal Reserve can do little to curb rising prices.

The ethanol program is pushing up food prices, and robust growth in China and elsewhere in Asia are pushing up energy and raw material prices. The Fed could only marginally affect these pressures by constraining U.S. growth.

The Federal Reserve’s aggressive interest rates cuts will have a limited effect on GDP and employment growth, and the stimulus package is likely to be too little and arrive too late to head off a recession.

The stimulus package at $152 billion is only about half as large as the losses taken by the major New York banks and their customers on subprime securities. Its value will be to lessen the pain imposed by whatever slowdown or recession the economy endures, not to head it off entirely.

The Federal Reserve is in crisis, because its mix of policies addresses an old style recession, one premised on inadequate demand but solid financial institutions. This recession has its origins in questionable banking practices and a breakdown of investor trust in the integrity of Wall Street’s most venerable banks and investment houses.

Federal Reserve regulators, apparently lacking appreciation for the gravity of these problems, have focused mostly on urging banks to raise new capital without effective parallel efforts to reform bank business models and practices. Often, new capital has been provided by sovereign wealth funds or private equity firms, which lack sophistication in the intricacies of commercial and mortgage banking and demand few changes in bank management policies. The result is sophisticated buyers of fixed income securities, such as insurance companies, remain unwilling to accept loan-backed securities from the banks. The market for mortgage backed securities issued by commercial banks has evaporated.

The housing sector is already in recession, in large measure, because the market for mortgage-backed securities has broken down. At this time, banks can only write conforming loans that can be sold to Fannie Mae or held on their balance sheets. The bond market will not accept mortgage-backed securities underwritten by the major Wall Street banks, and this significantly curtails the market for less than prime securities.

The whole chain that creates financing for mortgages and other consumer loans has been corrupted from loan officers to banks that bundle loans into securities, to bond rating agencies like Standard and Poor’s who demand payments from banks instead of charging investors to evaluate mortgage-backed securities.

The Federal Reserve and Treasury need to prod the private banks to reform lending practices, and to encourage bond rating agencies to return to investor financed ratings. Unfortunately, Henry Paulson and Ben Bernanke have been shy to do this. That is why the stock market has not been much moved by recent interest rate cuts, the dollar is so weak against the euro and gold prices continue to rise.

The economy is sailing through dangerous, unchartered waters, and Henry Paulson and Ben Bernanke, the helmsmen, seem confused and unsteady, adding to pessimism about the outlook for GDP growth and jobs. This pessimism is depressing stock prices and the exchange rate for the dollar against the euro, and it is pushing up the price of gold.

The weak dollar and high price for gold are a financial market vote of no confidence for Paulson and Bernanke.

Further Federal Reserve interest rate cuts are certain but these will do little to improve the growth prospects for the economy or the job market for ordinary workers.

Weak Wage Growth and Unemployment

Construction, manufacturing, finance, and retail trade displayed weakness, reflecting a contracting economy.

Wages decreased one cent per hour, or 0.1 percent. Wage stagnation and strong labor productivity growth should help keep core inflation in check, and this should help abate Federal Reserve concerns about nonfood and nonenergy price inflation, so-called core inflation, as it navigates the fallout from the subprime crisis. What problems the Fed faces in the core will be pass-through from higher food energy prices, which its policies can little affect.

The unemployment rate was 4.8 percent in January. However, these numbers belie more fundamental weakness in the job market. Discouraged by a sluggish job market, many more adults are sitting on the sidelines, neither working nor looking for work, than when George Bush took the helm. Factoring in discouraged workers raises the unemployment rate to about to 6.8 percent. As the economy slows further this figure will likely exceed 8 or even 9 percent.

Overall, the pace of employment growth indicates the economy is contacting. First and second quarter growth in GDP should be in the range of negative 0.6 percent. Ford and GM have announced second quarter production cutbacks and builders have a 10 month supply of unsold new homes. Auto production and housing starts should not improve much until the third quarter, and those conditions will feed into the rest of the economy. The jobs outlook should not markedly improve until at least the second half of this year.

Most forecasts of likely GDP and jobs growth are premised on econometric models, whose parameters were estimated using historical data. These historical estimates reflect a sound banking system and functioning credit market for mortgage and auto loan backed securities, but both the banking system and the securitized debt market are in disarray. Treasury Secretary Henry Paulson is studying the problem, and Federal Reserve Chairman Ben Bernanke has been mysteriously silent. Therefore, the rebound most econometric models predict for the third quarter may prove tepid indeed, and the economy could even continue to contract through the third quarter.

The bottom line is that labor markets will remain slack and keep wage increases down in months ahead. Recent increases in energy prices have passed through to core, nonenergy and nonfood, prices but these shocks are not becoming built into wage setting behavior and expectations for future inflation. The Federal Reserve can focus on managing the credit crisis, and further interest rate cuts are a virtual certainty.

Manufacturing, Construction and the Quality of Jobs

Going forward, the economy will add some jobs for college graduates with technical specialties in finance, health care, education, and engineering. However, for high school graduates without specialized technical skills or training and college graduates with only liberal arts diplomas, jobs offering good pay and benefits remain tough to find. For those workers, who compose about half the working population, the quality of jobs continues to spiral downward.

Historically, manufacturing and construction offered workers with only a high school education the best pay, benefits and opportunities for skill attainment and advancement. Troubles in these industries push ordinary workers into retailing, hospitality and other industries where pay often lags.

Construction employment fell by 38,000 in February. This is a terrible indicator for future GDP growth.

In December, manufacturing has lost 52,000 jobs, and over the last 91 months manufacturing has shed more than 3.6 million jobs. Were the trade deficit cut in half, manufacturing would recoup at least 2 million of those jobs, U.S. growth would exceed 3.5 percent a year, household savings performance would improve, and borrowing from foreigners would decline.

The dollar remains too strong against the Chinese yuan, Japanese yen and other Asian currencies. The Chinese government artificially suppresses the value of the yuan to gain competitive advantage, and the yuan sets the pattern for other Asian currencies. These currencies are critical to reducing the non-oil U.S. trade deficit, and instigating a recovery in U.S. employment in manufacturing and technology-intensive services that compete in trade.

Sadly, Treasury Secretary Henry Paulson in a speech to the Economics Club of Chicago expressed the view that the employment situation in manufacturing is healthy. With such apathy from the Administration it is small wonder that blue collar workers and their unions question the efficacy of U.S. trade policy.

A crisis of confidence has emerged, and the Administration and Ben Bernanke ignore it at peril of the nation.

PETER MORICI is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission. He can be reached at pmorici@rhsmith.umd.edu

 

 

 

 

 

 

 

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PETER MORICI is a professor at the Smith School of Business, University of Maryland School, and the former Chief Economist at the U.S. International Trade Commission.

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