When President Reagan proposed the 1982 budget, economists scoffed that it was a “rosy scenario” based on unrealistic GDP and employment forecasts. The economists were right.
However, Reagan’s assumptions were based on the belief that the tax cuts would spur the economy. They did. It just took longer than he thought it would take for the effects to be felt. President Obama’s rosy scenario is based on the apparent belief that the economy will be spurred by tax increases–an economic theory previously unknown.
Government receipts in his budget forecast are based on a decline in GDP of 1.2% in 2009 followed by an increase of 3.2% in 2010. How realistic is that?
Last quarter (which, since the government’s fiscal year begins in October, was the first quarter of 2009) GDP fell by a whopping annualized rate of 6.2%. This quarter doesn’t look any rosier:
Before Friday’s report was released, many economists were projecting an annualized drop of 5 percent in the current January-March quarter. However, given the fourth quarter’s showing and the dismal state of the jobs market, [president of ClearView Economics Ken] Mayland believes a decline of closer to 6 percent in the current quarter is possible.
Do the math. If in the first two quarters of FY2009 the economy falls at annualized rates of 6.2% and 6.0% respectively, that means for the total yearly decline to be only 1.2%, the economy will have to expand 3.7% in the second half of the year. That’s not even remotely feasible. It is more likely that, best case, the economy in FY 2009 shrinks by 4%, and worst case, shrinks by 8%. The current estimate of a $1.75 trillion deficit this year is, therefore, likely to balloon well past $2 trillion, since as the economy contracts, so too do tax receipts.
The Administration is not the only ones using unrealistic assumptions. The FDIC in its “stress testing” of bank assets assumes a worst case output decline of only 3.2% when it calculates bank assets. Equally as ludicrous is its assumption that the value of real estate will fall between 7 and 22 percent. A 20 to 40 percent decline is more reasonable–particularly since California and Florida are already well into that range, and those two states account for a disproportionate amount of the value of total outstanding mortgages. Many of the banks that “pass” the unrealistic stress test will really be insolvent. The market will know that even as politicians pretend otherwise.
The sad fact is that in many parts of the country the market price of a home is well below replacement cost, and there is little opportunity for the market price to rise significantly. Here is why. The rule of thumb is that a prudent home buyer can afford a mortgage about three times his household income. Four times is pushing it. In California at the peak of the boom, median house prices were eight or more times the median neighborhood household income. People could “afford” it because the price of real estate always goes up and they were bolstering their income with returns from investments in the market. Both of those are gone. Gone also are jobs. The unemployment rate in the Golden State is 2% higher than nationally. [Just in: the California jobless rate is now up to 10.1%] And with the passage of a state budget adding another 14 billion dollars of tax burden to Californians, the exodus of California companies is likely to increase unemployment further still. Housing prices must come down to a more reasonable three to four times earnings. Eventually, against all government attempts to prevent it, they will. (Spend some time reading this site to learn how bad it really is in CA.)
Yes, that means that many mortgage notes in high growth markets are probably worth only half their face value. Even worse, it means that new house construction in those places is at a dead stop until market values rise to where they exceed construction costs. That will be years in some areas, perhaps a decade or more in the most overbuilt communities. It will also mean that once construction does begin again, houses will be smaller and more in line with incomes.
Even if you don’t live in those areas, you are affected. Take away the construction boom in those two states, plus Nevada and Arizona, and you’ve elminated millions of jobs, and billions of purchases. Take away the leverage that those paper assets gave to both individuals and companies, and you’ve reduced overall consumption by a double-digit percentage.
How much leverage is that? By one estimate the domestic portion of the US stock market was once $20 trillion. Conservatively, that has fallen to $14 trillion. The total value of outstanding mortgages was over $14 trillion. The real value of those mortgages is now probably more like $10 trillion. Between those two asset classes, Americans have lost at least ten trillion dollars of wealth in the last year–or about two-thirds of the country’s GDP. That’s a lot of leveraged consumption that no longer exists.
Worse still–at least in the short term–is that, confronted with the economy, people and businesses are paying down loans and saving a greater portion of their incomes. This puts further downward pressure on spending. Although in the long term this is a good thing since individual savings is dreadfully low in this country.
But there is another reason individual savings has increased in recent months: the people are smarter than their government. Public pension funds are underfunded. People are figuring out that no matter what the government promised them, they will have to provide for their own retirements. Or at least, the smart people are figuring that out and are preparing for it. The remainder will have nothing and will turn for help to a government that also has nothing. California is already insolvent. It will soon be bankrupt, if not de jure, at least de facto. It’s not just California’s problem. What will happen there in the next year or two is prelude to the nation’s social security and medicare insolvency. You will not get what the government promised you; plan accordingly.
There are too many people at fault to even begin casting blame. All of us, in some way, bear some responsibility. But presidents, especially, own the nation’s problems. There is no doubt that the last president gave the nation a recession. But the new president gave us change. His policy changes are the perfect recipe for a double dip recession, the second dip being a result of crippling taxes just as the economy begins to improve, combined with inflation as a consequence of astronomical increases in borrowing. You can keep that change.
What I wrote is so obvious that today even the New York Times gently nudges the Obama Administration into realizing that there is a “sense of disconnect between the projections by the White House and the grim realities of everyday American life.”
If, as is widely anticipated, the economy grows more slowly than the White House assumes, revenue will be lower, forcing the government to cut spending, raise taxes or run larger deficits.
Economists also criticized as unrealistically hopeful the assumptions by the Federal Reserve as it began so-called stress tests to gauge the health of the nation’s largest banks.
The economy is already several decision cycles inside the President’s OODA loop, and that’s why he is floundering.