While Europe is grabbing a lion’s share of the economic headlines, it is not the only problem beguiling the U.S. economy. A wide range of structural problems pose a continuing threat to growth. In the best of times, these problems would simply limit the pace of growth. In difficult economic times, they make the economy more vulnerable to recession. These structural challenges include:
- the contagion effects from a European meltdown
- a deepening of the liquidity trap that makes the Federal Reserve’s task of managing monetary policy more difficult
- structural problems in the labor market due to a mismatch between the job skills, location of the unemployment, and the available job openings
- a sharp reduction in the pace of new business formation
- private sector debt reduction that still has a long way to go.
Where Europe goes, the United States will follow
The European economy moved into a recession in the second quarter of 2012. For the Eurozone as a whole, real growth fell 0.1 percent in the first quarter of 2012 from a year ago. The decline in growth was most notable among the Club Med countries of the Eurozone: Greece, Italy, Spain, and Portugal. Growth was also negative in the Netherlands and non-euro-using Hungary and the Czech Republic. Quarter-over-quarter growth declined in the United Kingdom and Ireland. The pace of decline accelerated in the second quarter as the financial problems of the continent’s banks sent interest rates rising and real growth sliding.
The financial crisis of 2008 started in the United States and spread to Europe. In 2012, Europe is returning the favor. Since the creation of the euro, the U.S. and the Eurozone economies have been economically joined at the hip (see figure 1). The hopes that the U.S. economy can somehow decouple from Europe is not supported by the data. The correlation between U.S. and Eurozone economic growth over the past decade has been a very high 89 percent. Europe’s recession will be transmitted to the United States through trade, European investment in the United States, banking, and the performance of U.S. companies with material European operations.
Transmission mechanism: Trade
The recession in Europe is having a direct impact on U.S. exports (see figure 2). Europe accounts for roughly a quarter of all U.S. exports. Coming out of the deep slump in 2009, U.S. exports to Europe soared, rising more than 25 percent by early 2011 from the previous year. As the European financial crisis grew, U.S. export growth slowed. However, exports were still up 15.6 percent as recently as February of this year. In April, exports were down 2.8 percent, a dramatic 18.4 percent contraction in the pace of growth in just two months. The last time we saw a collapse of this magnitude was in the fall of 2008, making U.S. exports to Europe another recession marker for both the U.S. and the European economies.
The contraction of trade is having a negative effect on a number of trade-dependent industries. Manufacturing has been particularly hard hit. This showed up in weak industrial production numbers in the United States and a June Purchasing Managers’ Index below 50 for the first time since 2009, a sign of contraction in the manufacturing sector. Going forward, manufacturing is facing a much more difficult road as new orders for a number of trade-dependent manufacturing sectors have been trending down since the first of the year.
Even as the construction industry shows some signs of life in the United States, new orders for construction equipment have fallen 8.7 percent since the first of the year. While the oil patch in the United States is in the midst of a drilling boom, businesses that supply equipment for the sector have seen orders plummet 29.6 percent. In all of these cases, the weakness in new orders for these capital goods is coming from outside of the United States.
Transmission mechanism: The banking system
As the banking system has grown more global, credit contractions in one part of the world can have negative effects elsewhere. The contraction of credit in Europe is putting pressure on European banks to raise capital. They can do this by issuing new equity or by selling assets. As selling equity dilutes existing shareholders, most European banks have taken the latter option of selling assets.
As Europeans divest themselves of U.S.-based assets (see figure 3), it contracts bank reserves in the United States, reducing the availability of credit. The U.S. Federal Reserve has more than offset this contraction of reserves through multiple rounds of quantitative easing. Still, as the Europeans sell their U.S. assets and go home, it puts downward pressure on prices while reducing the availability of capital for investment in the United States.
Source: Organization for Economic Cooperation and Development
Figure 1: GDP growth rates: United States and Eurozone
Source: U.S. Department of Commerce
Figure 2: U.S. exports to Europe
Source: U.S. Department of Treasury
Figure 3: Eurozone Investment in the United States
Transmission mechanism: Corporate profitability
U.S. businesses do more than just trade with Europe. Many have set up shop and conduct business in Europe. From automakers to quick service restaurants, U.S. businesses have extensive operations in Europe. And like the rest of the continent, the European operations of U.S. businesses are hurting. In the first quarter of this year, problems with European operations were a common excuse given for disappointing earnings. That excuse has continued in company guidance for soon-to-be-released second quarter results.
The contraction in U.S. company earnings in Europe has translated into an actual decline in first quarter earnings of U.S. companies in total. While profits from domestic businesses rose by $41.7 billion, profits from overseas operations fell by $48.1 billion. For the first time since the fourth quarter of 2008, profits declined by $6.8 billion (see figure 4). As a share of GDP, profits shed 20 basis points to 12.8 percent. This declining share of GDP is a reflection of the growing pressures on margins due to increased labor and regulatory costs.
As firms feel the pinch on profits, we can anticipate that they will respond with renewed emphasis on cost cutting in an effort to restore margins. As a result, weakness in job growth and business investment can be expected to follow the decline in profitability.
Source: Bureau of Economic Analysis
Figure 4: Corporate profits
Source: Federal reserve board
The liquidity trap deepens
An increase in cash levels since the first of the year is a clear sign that the level of economic uncertainty has risen (see figure 5). While uncertainty over Europe has grown, so too has concern over the fiscal cliff faced by the U.S. government, the future status of health care reform, the future role of the federal government in regulating oil and natural gas drilling, and the pace of roll out of Dodd-Frank regulations. Banks and corporations have responded to this growing level of uncertainty by holding more cash.
Since the first of the year, cash holdings by U.S. commercial banks have risen by $129.9 billion or 8 percent. Cash as a share of total assets has grown by 59 basis points to 13.4 percent. Before the recession hit in late 2007, cash holdings by commercial banks averaged less than 4 percent.
While corporate cash took a small hit during the recession, their stash of cash has risen by more than $220 billion since the end of the recession to $1.29 trillion.
The problem with banks and corporations holding more cash is that it deepens the Federal Reserve’s liquidity trap. A liquidity trap occurs when the demand for money rises and offsets the central bank’s efforts at increasing money supply. Not surprisingly, the demand for money goes up during a recession as businesses, households, and banks all attempt to hold more cash out of a fear of insolvency or unemployment. The banks significantly increased their cash holdings during the 2008–2009 recessionary period. Cash holdings for both banks and corporations rose again last year due to banking problems in Europe, and they are rising again for much the same reason.
Structural labor market problems dampen employment growth
The labor market remains a major drag on economic recovery. Long-term unemployment set records even as the economy has recovered. Median duration of unemployment, which has only rarely exceeded 10 weeks during the most severe recessions, jumped to 25 weeks in mid-2010 and remains above 20 weeks three years into a recovery.
Jobs are getting harder to find, and more job seekers have simply given up looking for work. The result has been a significant drop in the rate of labor force participation. Workers who are not looking for work are not accounted among the unemployed. Were the labor force participation rate at the same level as it was at the beginning of the recession, the unemployment rate would be a full 2 percentage points higher.
Historically, there has been a close relationship between job openings and the unemployment rate (see figure 6). As the number of job openings increased, not surprisingly, the unemployment rate fell. Since the beginning of this recovery, there has been a shift in this relationship. Given that the labor force participation has fallen sharply, one might suspect that it would take fewer job openings to drive down the unemployment rate since a declining rate of labor force participation pushes down the rate of unemployment. In fact, the exact opposite has happened.
Since the first of the year, the rate of job openings has averaged 2.5 percent of total employment. In the last decade, that level of job openings would correspond to an unemployment rate of around 6 percent. During this recovery, there has been a shift in the relationship between job openings and the unemployment rate. It now takes a much higher rate of job openings to drive down the unemployment rate. The shift in this relationship is a reflection of an increased incidence of structural unemployment.
While jobs are being created, they don’t match up with either the skills or the geographical location of the unemployed. Reducing structural unemployment is a difficult task that requires some combination of retraining the unemployed and increasing labor force mobility.
Source: U.S. Department of Labor
Figure 6: A mismatch of skills: Job openings and the unemployment rate
Source: U.S. Department of Labor
Figure 7. New business creation and destruction
A missing job creator: New business formation
A second reason for the weak performance of the economy in general and employment growth in particular has been the unprecedented low rate of new business formation. During the recession of 2007–2009, the pace of new business creation fell to its lowest level in more than 30 years (see figure 7). At the same time, the pace of business destruction rose although not nearly to the levels seen in the 2001 or the 1981–1982 recessions. Given the severity of the recession, it is surprising that the pace of business destruction was not significantly higher.
The long-term decline in new business creation is due, in part, to demographics. An older population is going to be more risk averse and less likely to start new businesses than a younger population. Even though the trend in new business creation has been downward, the sharp fall in 2008–2009 was unprecedented and could reflect the cost of higher levels of business regulation.
This time really is different: The private sector de-levers
Over the past 80 years, deep recessions have always been followed by robust recoveries. In the first three years of recovery from the Great Depression in the 1930s, real GDP growth averaged more than 10 percent a year. After the oil shock recession of 1973–1974, real growth averaged 5.1 percent for the next three years. The double-dip recessions of the early 1980s were followed by three years of growth that averaged 5.3 percent. In each case, once the Federal Reserve began to ease credit policy, pent-up demand in credit-sensitive segments of the economy like housing and autos soared.
One of the big differences between then and now is the role of debt. In each of those previous deep recessions, the private sector came out of the recession in a position to take on more debt. That has not been the case this time. To the degree that the increase in debt is a loan of future growth to the present, debt deleveraging is a repayment for past growth by the present. Households, businesses, and financial institutions have all been aggressively reducing debt. While this is a healthy and necessary development, it creates a major headwind for current growth.
Source: Federal reserve board
Figure 8: Private sector debt as a share of GDP
Even with the unprecedented reduction in debt over the past four years, debt levels today are only back to where they were in early 2005 (see figure 8). Much of this reduction in debt has come from the write down of defaulted-upon mortgages. Millions of homeowners are still underwater. With the foreclosure rate running near record levels, a lot of mortgage debt remains to be written down.
As banks write down the bad debt they are carrying on their books, profits will suffer and additional capital will need to be raised either through the sale of assets or the issuing of more equity. Either way, banks will have less capital to lend in the short run, which will keep the private sector deleveraging for some time to come. As households and businesses de-lever, money that could have gone to current spending is used to pay down debt. In all cases, deleveraging leads to slower growth.
Conclusions and observations
The U.S. economy has dodged one bullet after another over the past year in a successful and unprecedented effort to avoid recession. On a year-over-year basis, the U.S. economy has managed to grow less than 2 percent for four consecutive quarters. The previous record of less than 2 percent growth without a recession was the three-quarter stretch from Q4 2002 to Q3 2003. Every other case where less than 2 percent growth lasted more than two quarters was associated with a recession. With the recession spreading in Europe, the ability of the U.S. economy to continue growing in the face of its four structural issues seems increasingly unlikely.