This economy makes no sense and nobody knows why
Nobody can figure out how best to describe the current economy although some have tried. Last Friday’s jobs report only made that task harder. A total of more than 250,000 jobs were added for the month of April and the unemployment rate went down to 3.4%. That happened despite the chaos that has afflicted part of the banking sector and the likely tightening of credit that has come from it.
Predictions of a recession have been widely made by economists and others for more than a year now. Last summer, there was a debate about whether we were in a recession. Interest rates were being raised at a fast clip and gas prices were very high. The latter has since come down, but the former has not. Interest rates were raised again last Wednesday. That was thought to be the last raise for a while, but, after the jobs report, maybe not.
I’m not certain about many things, but I’m pretty sure we aren’t in a recession now. Recessions see jobs getting lost, not added by the hundreds of thousands each month. There is no way, no how an economy with an unemployment rate of 3.4% is in a recession.
For a while, there was a debate about where all the missing workers had gone. There were many more job openings than there were people looking for jobs. That debate is all but over and has been replaced by a debate about where all the suddenly available workers came from. The share of the total population that is employed is now higher than it was before the pandemic.
It turns out, a tight labor market works wonders. When employers have to compete for workers, they usually raise wages. Higher pay tends to bring workers off the sidelines. Last decade, there was a labor surplus, but employers still had trouble filling some jobs. There was talk about a “skills gap” where workers didn’t have the skills to do the jobs employers needed and the solution was to somehow retrain the workforce. That idea turned out to be false. Because there were more workers than jobs, employers weren’t paying workers as much and so there was less willingness to do some jobs. Now that workers are getting paid more, there’s more willingness to do those jobs.
All the good news on jobs notwithstanding, inflation still remains high. It is no longer at 9%, but is in the 4-5% range. Over the last few months, it hasn’t increased, but it hasn’t decreased by much either. One piece of good news on that front is that rents are set to fall. When inflation first took off in 2021, it was mostly goods and energy prices that were affected. Now, it is services prices that are contributing the most to it.
Services inflation is heavily impacted by rents. Since 2021, rents have gone up significantly in many places, but that now is starting to reverse. A problem with inflation data is it is often lagging, particularly when it comes to rents. Because rents are usually set on an annual basis, it takes time for that data to show up in official inflation calculations. The upshot is that inflation may be lower than what official calculations are showing now.
Consumer sentiment still remains very low. Inflation certainly has something to do with it, but I’m hard pressed to think it has everything to do with it. Nearly everything today is influenced by partisanship and not even feelings about the economy can escape that. With a Democratic president, Republicans are much more likely to be downbeat about the economy even if their own personal situation is fine. Conversely, Democrats are more likely to say the economy is good no matter their own personal situation.
I think people are down on most everything these days. Whether it’s the economy, politics or quality of life, people are inclined to think negatively about it. Sometimes that reflects reality, but other times it’s very detached from it. Media coverage plays a part in that as it tends to cover most things from a negative angle. Social media makes things even worse by letting people hear about bad things they otherwise wouldn’t. It’s easy for things to go viral even (or especially) if they’re false or misleading.
Why the job market is still thriving
Unemployment is low despite the yearlong increase in interest rates. Job vacancies have begun to decrease while wage increases have slowed. It was thought by some that the only way wage growth could slow is by having unemployment increase, but that hasn’t happened. Historically, when job vacancies have declined, unemployment has gone up, but that hasn’t happened either. This economy has shattered so many widely held economic beliefs that it’s hard to keep track of them. Anyone using models that look at past economies to try to predict where this economy is headed is going to step on rakes.
The rapid raising of interest rates has had an effect on certain parts of the economy. Most notably, that is what partly did in Silicon Valley Bank (SVB) and has made some fearful of another banking crisis. The tech sector has also been affected. Hardly a day goes by when a company in that sector doesn’t announce layoffs. It’s a 180 degree reversal from last decade where unemployment was high and the tech sector thrived.
Why have interest rates not had any negative effect on employment? There doesn’t seem to be any solid consensus, but there are some possible answers. One is that the raising of interest rates will have an effect, but it takes time for that to materialize. When the Fed raises interest rates, it is raising the rate that banks charge other banks to borrow from each other. Banks respond to that by raising the interest rates they charge to the non-bank entities they lend to. That process takes a while to work its way through the broader economy.
Another explanation is that it’s because most people aren’t employed in interest rate sensitive sectors anymore. Most jobs are in the services industry, which relies less on debt compared to manufacturing. The biggest expense service providers often have is labor costs. They may be less likely to borrow just to hire more workers as opposed to buying expensive machinery and equipment. A business that borrows very little or not at all is unlikely to be directly impacted by rising interest rates.
A third explanation is that fiscal policy is still having an effect in boosting demand. The last stimulus legislation was passed in March 2021. Still, the amount of stimulus done was massive and it takes time for it all to get spent. In addition to stimulus legislation, Congress passed legislation dealing with infrastructure, semiconductors and climate change. That money is starting to get spent and has encouraged private sector actors to spend money as well.
The amount of fiscal policy done during the last two years has arguably countered much of the increase in interest rates that has happened in the last year. Borrowing is more expensive, but projects of all sorts are subsidized by the federal government, making it less expensive for the private sector to take part in it. Many states have been using their budget surpluses to cut taxes, which will boost consumer spending, too.
The job market has proven to be incredibly resilient. Prior to last year, most people probably would have thought an economy that saw interest rates go from zero to nearly 5% in a year would be in a recession by now. Housing has been hit hard, the tech sector has lost its halo and some mid-sized banks are on edge, but jobs still keep getting added. Maybe this is all the calm before the storm and unemployment rises like it historically has when borrowing becomes more expensive. Then again, maybe we have no idea how the economy really works and past experiences aren’t any guide.
Threats to the economy
There certainly are dangers out there. The raising of interest rates almost always breaks something. In any economy, there will be businesses whose profitability depends on low interest rates. It can be an industry like real estate, which uses lots of debt. It can be an industry like Silicon Valley, which often finances startup companies that dazzle investors, but don’t turn a profit. Investors may be willing to throw money at most anything when interest rates are low, but once they go up the party’s over.
The most immediate risk now is obvious and 100% manufactured. That is the debt ceiling standoff. Breaching it would mean the US has defaulted on its bond payments for the first time in its history. The debt ceiling is just plain stupid. No other country in the world has one other than Denmark, which only has one on paper. It has been around for a little more than a century and was essentially created by accident.
The debt ceiling didn’t matter for the better part of 100 years because it was never weaponized. It was common for the minority party in Congress to vote against raising it knowing that it was all for show. Now, House Republicans are weaponizing it again like they did in 2011. They are the only reason this standoff is happening. Biden is right to not want to encourage it being used for extortion. Still, he won’t get a clean raise and will have to give House Republicans a little something. Whatever that little something is, it should be done conditionally on raising the debt ceiling at least until 2025.
The next time Democrats are fully in charge they should get rid of it. The benefits of having it are zero. At best, it’s a charade we go through every few years where people get worked up for no reason. At worst, the US risks defaulting on its bond payments and causing a worldwide recession or worse. I’m not a believer in the idea that the US dollar is losing its status as the global currency, but if that happens that may change. I can’t think of anything that would be better for China.
The debt ceiling standoff is the most immediate risk, but not the only one. The banking panic that did in SVB and First Republic may not be over yet. The biggest problem banks like SVB had were that their depositors were almost all uninsured. I don’t know how many other banks are like that, but I’m sure they exist. The panic that brought down SVB may come for them.
Commercial real estate may be in for hard times. Office buildings in many downtown areas aren’t as full as they were pre-pandemic. With remote work becoming much more common, the valuations of many office buildings have gone down. The risk for commercial landlords is that tenants will either not renew leases or will renew them for much less. That would put a dent in their revenues while making them vulnerable to foreclosures.
In that case, landlords may be looking at bankruptcy while lenders would take possession of buildings worth less than the amount of money loaned against them. That could hit some banks hard and maybe cause another banking panic. One big question is how quickly that would unfold. Loans and leases are not all due at the same time. It may wind up being a slow moving crisis rather than a nationwide collapse like in 2008.
Even if there are bankruptcies and foreclosures on commercial buildings it still wouldn’t be as bad as 2008. Banks would take a hit, but they would at least have a real asset that actually exists. Office buildings may lose some value, but they are real things that still have uses. That is different from 2008 where bank and other lender losses came from derivatives that existed only on paper.
It is likely that many downtown office buildings won’t be as occupied as they were before 2020. Downtown areas would be well-served by converting as many office buildings to residences as possible. That would be good for increasing the housing supply and good for banks because it would likely increase the buildings’ valuation. For those who like downtown areas and don’t want to see them decline, restoring things to where they were in 2019 isn’t going to work, but new residents just might save the day. For example, while there is less demand for working in Manhattan compared to four years ago, there is a ton of demand for living there.
As far as other risks to the economy go, there is always the danger of an oil price spike. That doesn’t seem like something that will happen now, but who knows what the future holds? A war in the Middle East could easily cause it to happen. Russia is unlikely to cause a spike now, but if things go horribly for them in Ukraine and they get desperate, who knows? The good news is the ability of any one country to cause a spike has limits. There are risks to doing that such as losing market share and buyers.
The debt ceiling is the most obvious and acute danger. Other dangers are certainly out there, but that is the only one that would definitively be catastrophic if it happened. Problems in commercial real estate could be very bad or not. Interest rates rising and/or staying high could cause a recession or not. An oil price spike would be bad although how bad would depend on how high it went and for how long.
Beware the prognosticators
Those risks are just the ones I can think of. I have no doubt there are many more out there. I’m not in the prediction business, but I have a gut feeling that the next downturn won’t be caused by any of the risks being discussed today. That’s not based on any special insight, just going with my gut. I have heard of plenty of economic downturns, but I haven’t heard of one that everyone thought would happen. Yes, I realize I’m de facto predicting the debt ceiling won’t be breached. That’s not 100% certain, but it is one of those things that’s so obviously bad that it likely forces some kind of last minute deal.
I don’t recommend this as a rule of thumb, but given how poor of a track record economists have of predicting recessions, you could do worse than by assuming the opposite of what they think on that matter. Right now, most economists seem to think we’re headed for a recession this year. Make of that whatever you will.
Economists have plenty of good uses, but they aren’t prophets. The same is true for people in business. There are plenty of people who are successful in business and are very good at the one thing they do. The problem many of them run into is they think that because they are good at, say, running clothing stores, that means they know everything about everything. It doesn’t help that they probably surround themselves with people who tell them how wonderful and perfect they are (cc: every billionaire hedge fund manager).
What I’m getting at is that if you’re looking for someone who can predict where the economy will be even in just a short while, don’t bother. Nobody has any idea what things will be like in just a few months, let alone longer. There are tons of people now collectively making every possible prediction. Inevitably, someone will be right, but that will have more to do with luck than foresight. I would wager that virtually all of those who wind up being right about the next downturn were wrong about the previous ones and will be wrong about future ones.
There is no particular kind of person who gets everything right. No matter what someone’s background is, there is no foolproof way to go about doing things. All of us are fallible and get things wrong. When it comes to predicting where the economy is headed, we’re all in the same boat. The reality is none of us have any idea.