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 United States during the first three quarters of 2010 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 2010 brought a welcome change, with consumer spending rising at a 4 percent annual rate, enough to increase total real GDP by 3.1 percent from the third quarter to the fourth. The economy seemed to have escaped its dependence on inventory accumulation. This favorable performance led private forecasters and government officials to predict continued strong growth in 2011, 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 two percentage points was enacted in order to lock in this favorable outlook.
Unfortunately, the projected recovery in consumer spending didn’t 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% in January, down from the previous quarter’s 4% 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%. 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 housing construction. That decline is likely to continue, because nearly 30% 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 doesn’t pay, but cannot take other assets or a portion of wage income. As a result, 10% 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 indices maintained by the Institute of Supply Management falling for both manufacturing and service firms. Although large firms 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 nondefense capital goods signaled 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 new jobs were created, less than one-third of the average for employment growth in the first four months. As a result, the unemployment rate rose to 9.1 percent of the labor 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 percent, 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 percent. 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 US Federal Reserve will maintain its policy of keeping the overnight interest rate at near zero; but, given a fear of asset-price bubbles, it will not reverse its decision to end its policy of buying Treasury bonds – so-called “quantitative easing” – at the end of June. Moreover, fiscal policy will actually be contractionary in the months ahead. The fiscal-stimulus program enacted in 2009 is coming to an end, with stimulus spending declining from $400 billion in 2010 to only $137 billion this year. And negotiations are under way to cut spending more and raise taxes in order to reduce further the fiscal deficits projected for 2011 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 2012.
Martin Feldstein, Professor of Economics at Harvard, was Chairman of President Ronald Reagan’s Council of Economic Advisers and is former President of the National Bureau for Economic Research. © Project Syndicate 2011.