The Perfect Storm

For the better part of a decade, Michigan’s economic performance has paled morbidly in comparison with the nation’s overall growth. Now with the American economy drifting toward inflationary stagnation and a true national recession looming large on the horizon, economist David Littmann examines our state’s failed policies and proffers new ways for Michigan to improve its prospects by cutting taxes and streamlining government
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the perfect storm
illustration by paul vismara

Contrary to the conventional wisdom conveyed in an election year by a hyped media, the U.S. economy over the past seven years has enjoyed good growth and excellent productivity gains.

Fundamental performance in the second quarter of 2008 registered a real GDP expansion rate of 2.8 percent and year-over-year growth of 2.1 percent (adjusting for inflation). Real GDP growth provides important perspective for three reasons: It quantifies economic momentum that could bridge the tumultuous housing-value collapse and energy price threats to our wallets and psyches; it sets the all-important springboard from which our 2009-10 economic predictions are cast; and it establishes parameters for sorting truth from fiction in evaluating economic policies — past, present, and future.

Indeed, such policies have been the key to explaining the extended period of prosperity from 2002 to 2008. This 7- to 8-year U.S. business expansion is double the historical norm of 3 to 4 years. As of October 2008, despite waves of economic deceleration, mounting uncertainty, and the seizing up of financial markets, there’s still a chance the national economy can limit this second-half-2008 recession to a relatively mild, two-quarter contraction. Why? Largely for the same reason that the first years of the Kennedy and Reagan terms paved the way for the extended prosperities of the 1960s and 1980s, respectively. The common denominator is that both administrations proposed and presided over very significant reductions in income-tax rates. Tax-rate reductions spurred individual and business enterprise. Tax cuts augmented a willingness to work harder, longer, and smarter. Reduced tax burdens unleashed massive amounts of capital for new savings and investments. Moreover, the United States became a real growth engine for foreigners.

The expression “When you tax something, you get less of it” has a more inspiring counterpart: “When you cut taxes on something — incomes, for example — you get more of it.” This axiom captures an elemental economic and fiscal-policy truth. When President Bush and the Legislature slashed tax rates on earnings, dividends, capital gains, and estates (especially in June 2003), Uncle Sam’s budget deficits soon shrank from half a trillion dollars annually to just under $200 billion. Tax cuts revived business activity and generated burgeoning tax revenues to all levels of government, as well.

Federal budget deficits would’ve been transformed into large surpluses, had Washington not spent like drunken, uncontrollable sailors between 2002 and 2008.

Nevertheless, facts are facts. The economic truth is that the U.S. stock markets rose to record heights, as did U.S. auto and truck sales. U.S. job growth, worker productivity, and real earnings also rose to record levels, and the unemployment rate fell to the lowest average in three decades. No other advanced western economy enjoyed comparable prosperity. Between 2002 and 2007, the U.S. economy gained several percentage points of the western world’s share of total GDP and exports.

Basic Forecast Assumptions

The starting point for 2009’s economic forecast is, however, the recession of 2008. Although the second quarter’s real growth of 2.8 percent is considered respectable, the fact remains that whenever real quarterly GDP growth slides below 3 percent, unemployment rates rise. This is why U.S. jobless rates have risen rather steadily to 6.1 percent in September 2008 from a low of 4.5 percent in the prior year. Moreover, advance estimates for the third quarter show a -0.3 percent rate of contraction with an even more severe slide in the final quarter of 2008.

A weakening economy becomes vulnerable to domestic and international shocks, be they of an economic, financial, or psychological nature. Since mid-year 2008, many factors are compounding weaknesses in the U.S. economy. Painfully high energy prices have sapped the discretionary purchasing power of households. Higher transportation costs quickly translate into accelerating prices for consumer staples such as food, clothing, services, and imports. Anxiety over the likely demise of Bush-era tax cuts (post-2010) suggests that steep tax hikes will clobber household budgets, causing retrenchment in spending decisions by firms and individuals. Consumer spending is 70 percent of GDP. Superimposed on these worries is the recent depreciation of most family savings, retirement plans, and other investments.

 
michigan mega grant requests chart

In fact, the lightning-fast decision by Washington’s lawmakers to inject more than $125 billion of so-called “tax rebates” into household checkbooks at midyear was a gimmicky attempt to prop up the stumbling economy ahead of the national election. Incumbent politicians realize from ample first-hand experience that people vote their wallets. Without the temporary stimulus of more deficit spending from Washington, job losses along Main Street would rapidly claim jobs among many incumbent politicians along Pennsylvania Avenue.

Are there any other quick-fix arrows left in the policy quivers of the Federal Reserve (monetary policy) or the U.S. Congress (fiscal policy)? Not really. The Alan Greenspan era saddled us with a veritable “land-price bubble,” which has now morphed into the current blowout (and “bailout”) of firms tied to the housing-finance industry. Greenspan, the Fed chairman from 1987 to 2006, pushed bank-borrowing rates down to 1 percent and held them at these absurdly low rates for three years, at a time when inflation ran two to three times higher! In view of the early autumn crisis in financial markets, Greenspan’s successor at the monetary policy helm, Ben Bernanke, and his Federal Reserve Board are afraid to jump from the tiger of stimulative monetary policy, even as the inflation rate has climbed above 5 percent and threatens to accelerate in 2009. And now, like a mirror image of the tax rebates, Bernanke, prior to the national elections, has recapitulated the Greenspan policy by shoving federal funds rates down to
1 percent.

Similarly, U.S. senators and representatives wanted to jolt the U.S. economy once again before the Nov. 4 elections with additional rounds of deficit spending. But that policy proposal was quickly trumped when the shocking emergence of frozen financial markets prompted Washington’s calls for a new spending spasm: $700 billion in “bailout” funding. The bottom line? Both monetary and fiscal policy vectors during 2008 conspired to pump up the economy before the election. Consequently, the economy — as typically happens in a national election year — remained recession-free, at least for the first six months. Post-election, however, neither the Federal Reserve, nor the president, nor Congress has any compelling reason to supply massive injections of money or spending.

As the political transition of future President Barack Obama takes place during the first half of 2009, the U.S. economy will likely drift into a state of inflationary stagnation. Look for the following cross-currents of activity: the dollar’s ongoing weakness assures us that U.S. exports will continue delivering moderate growth, while consumer spending goes neutral. Housing will remain comatose, but fortunately, improving apartment activity will neutralize lingering softness and further detractions from real GDP. Government spending and purchases will continue uncontrolled (which registers as a growth component for GDP). Overall weaknesses in major consumer retail sectors, including autos, foretell serious contraction in business investment spending. After all, firms curtail production and reduce staffing as they watch their inventories of unsold goods and materials rise.

Recession by Year-End 2008

It’s almost a foregone conclusion that recession has overtaken the United States. Yet we know empirically, logically, and from textbook Econ 101 that the tipping point into negative GDP territory will likely return again by the final quarter of 2009, due to three principal events: Washington will reject extending Bush-era tax relief on salaries, wages, and investment income (tantamount to legislating a massive tax hike on firms and individuals); Washington will continue restricting oil drilling and construction of refineries or nuclear facilities, thus guaranteeing greater drains on consumer purchasing power and higher unemployment rates; and Washington will be obliged — by U.S. inflation rates and by global doubts about the long-term viability or integrity of the dollar — to tighten monetary policy, thereby raising interest rates and causing further erosion of stock prices.

This logical train of economic events owes its existence to a very sad political reality. In an off-election year (such as 2009), most of our elected officials calculate that a poor economy will not upset their chances for re-election. This is why nearly all post-World War II recessions have occurred after (or by the second year following) a national election. Occasionally, as in Jimmy Carter’s ignominious defeat by Ronald Reagan in 1980, conditions become so bad, so quickly, that voters have the opportunity to project their pocketbook pain on incumbents!

It’s equally difficult to ascertain precise timing of this secondary recession. Yet we can be certain that the economic reality of the recession’s onset will correspond to conditions of tighter credit, retrenchment of consumer confidence and spending, rising unemployment rates, deterioration of investment portfolios, and higher levels of unsold homes and business inventories. Movements of these traditionally reliable indicators offer advance warnings of recession. But by comparing 2009 levels of these indicators with 2008, we can date, define, and profile the next recession.

Industry Adjustments, 2009-10

The U.S. auto industry enjoyed its greatest annual sales and profits ever. The boom years of 2004-2006 reflected alignment of fortune’s stars: low auto-financing rates, lower income taxes, rapid gains in after-tax (disposable) income, affordable gasoline, and a series of the lowest unemployment rates in decades. The earlier income-tax-rate deductions made the cost of new cars and light trucks all that much more affordable. Thanks to greater auto affordability, motor vehicle sales in those boom years exceeded 17 million units.

However, for 2009-10, the vehicle-sales outlook is not encouraging. As of October 2008, annual vehicle sales plummeted below 13 million units, according to industry analysts. As of early fall 2008, Detroit’s automakers, hit by soaring gasoline prices and Washington’s stricter CAFE standards, had begun yet another round of layoffs, downsizings, and lobbying for Washington subsidies. We expect that the industry will sell fewer than 13 million light vehicles in 2009 and fewer than 14 million units in 2010. Detroit’s automakers will especially bear the brunt of Washington’s irresponsible dictates on mileage, domestic oil drilling, and refining.

In fact, considering these costly and counterproductive mandates, along with the high
probability that the soft U.S. economy will extend into early 2011 (the likely recovery year), Detroit’s automakers are very unlikely to survive as stand-alone domestic entities beyond the coming
downturn. No amount of federal loans and subsidies for low-demand, high-priced hybrid vehicles can reverse the damage being inflicted on auto companies whose chief domestic profits come from large and luxury vehicles.

 
projected state revenue 2008-09

But there is some good news. Despite layoffs and bankruptcies in the housing and auto industries, whose health relies on growth in discretionary household income, some industries always perform relatively well in economic doldrums. We call these industries “counter-cyclical.” Counter-cyclical industries include apartment builders and management firms, credit counseling and turnaround consultants, replacement parts and repair organizations, defense industries, educational institutions whose enrollments tend to rise when job openings are few, low-end retailers and discounters, less-expensive restaurants or entertainment industries, and so forth.

Fixing Our Financial Markets

October’s debacle in U.S. and global financial markets was rather easily defused by prompt and massive monetary injections by the Central Bank and Treasury Department. But reliquefication is a quick and temporary fix. Sadly, the systemic problem will remain, because government intervention omits true reforms that identify and remove causes of credit seizures and failed
confidence. Washington’s cancerous growth, control, and market interventions will escalate and, if not reversed, will precipitate a subsequent collapse.

This is not a pleasant prospect. In order to avert future financial disruptions or an end-game catastrophe, the following fundamental reforms must occur prior to facing an even more daunting and intractable $50-to-60 trillion storm of unfunded liabilities associated with the Medicare, Medicaid, state/local pension and health-care obligations, and Social Security programs, just to cite a few.

In 2009, investors must watch for one or more of the following changes in order to have confidence that their incomes, savings, and retirement nest eggs will not be expropriated by ruinous inflation or direct taxation:

  • Politically correct mandates, such as the Community Reinvestment Act of 1977, must be eliminated in order to return rational lending practices to credit markets (especially mortgage markets).
  • Federal agencies, such as Fannie Mae and Freddie Mac, endowed by lawmakers with particularly lax capital and accounting privileges that override and contravene marketplace disciplines, must be shed or privatized.
  • Senators and representatives who receive political campaign funding from government agencies must be investigated for conflicts of interest.
  • Credit-rating agencies, such as Moody’s, Standard & Poor’s, and Fitch, must be held liable for losses on securities and firms from which they’ve accepted fees in exchange for overrating their client’s quality.
  • Mark-to-market accounting regimens must be revisited by strict cost-benefit and contingency analyses.
  • Prolonged periods of endogenous Federal Reserve monetary expansion that exceeds trend growth of real GDP must be prohibited. By statute, those responsible for conducting such policies must be subject to prosecution. After all, inflation is theft and ultimately contributes to distrust and a breakdown of interpersonal financial transactions, world trade, and confidence in U.S. markets.

Most importantly, Congress must install a capital budget for the United States. Without a balance sheet with a capital budget dedicated to repaying debt obligations, our future will be one of financial chaos exceeding anything our history has known. If one or more of these reforms occur in 2009, then short-term interest rates, after increasing at least a full percentage point to reflect tighter monetary policy, should begin falling as slacker credit demand coincides with recession by year’s end. Long-term rates are likely to rise by only .25 to .50 percent. As a result, the yield curve narrows, foreshadowing by six to 12 months the oncoming, secondary recession. As usual, tight money policies lead to easier credit, and easy money foreshadows tight credit. This is the most important single economic lesson taught by the events of the previous business cycle, 2001-2008. This scenario  will likely replay itself between 2008-11.

Outlook & Impact on Michigan

Michigan’s economy, already in a six-year recession, will weaken significantly in 2009, both in absolute terms versus 2008 and relative to the national economy. The out-migration of Michigan’s most mobile workers and college graduates has thus far prevented an even sharper rise in our state’s unemployment rate (often the highest in the country). As the national recession progresses, however, Michigan will experience a surge in its jobless rate. During much of 2009, Michigan’s unemployment rate will likely soar into double digits. The reason is that a national recession curtails job openings and new business opportunities elsewhere. Hence, more job seekers remain unemployed in Michigan’s shriveling private sector.

Michigan’s fortunes always depend on low-cost financing and good gains in discretionary income. Discretionary income provides the wherewithal to purchase Michigan’s chief export, the large-ticket durable good known as the motor vehicle. Discretionary income in 2009-10 will grow only if tax rates are cut and inflation recedes. Without these conditions in 2009, our state stumbles again. More firms consolidate, move, or file bankruptcy. Michigan’s economic situation is made worse, not better, by continued expansion of Lansing’s total budget imbalance and spending profligacy. Here again, investors and graduates in 2009 need to watch Lansing for signs of permanently reduced total government budgets and tax rates in order to forecast some future year for Michigan’s economic turnaround.

 
health care: state employee-paid premium percentage

Michigan has historically been an astoundingly accurate bellwether of what awaits the nation. And it’s happening again. Economically speaking, our state is a veritable laboratory for a failed experiment in government intervention in private markets. Lansing’s full-time legislators and governors have increasingly taxed incomes in order to expand programs of regulatory control over our land, labor, and savings. As government expands, the productive, competitive, creative private sector diminishes, and growth diminishes with it.

This scene is now playing out at the national level. Unchecked government spending, including special-interest earmarks, allowed our elected officials to meddle in the housing markets and receive donations for their election campaigns. Special regulatory favors encouraged Fannie Mae and Freddie Mac to skirt rules that apply to honest firms in the private sector, thereby augmenting Fannie-Freddie’s domain and command over financial resources. As usual, moral hazard leads to collapse.

Ironically, the competitive market system is blamed for failures, while politicians and bureaucrats who are directly complicit in accounting and legislative scandals escape scrutiny and are free to plan their next (and probably fatal) surge to socialism: the “bailout” of Medicare’s tens of trillions of unfunded liabilities.

In summary, the 2009-10 economic and financial outlook is, without a doubt, the most critical period we’ve confronted in 80 years. The same kinds of reforms that Margaret Thatcher brought to Great Britain in the 1980s are imperative here. We must zealously guard our wallets and our economic choices and liberties or be prepared to live the coming decades in a second-rate state and nation that will be challenged economically, politically, and militarily by former friends and foes alike from all corners of the globe. Eternal vigilance is the cost of freedom and prosperity.

Senior Gains

By Terrence Oprea

It’s a good thing that business leaders in metro Detroit and statewide are focusing their energy on retaining college graduates and young entrepreneurs. Why? Because they’re the future; we need them if we want to grow.

But there’s another demographic that retailers, auto dealers, really any consumer-orientated company should consider. According to the Southeast Michigan Council of Governments, people 65 and over represent the only demographic that will grow in Michigan between now and 2035. Why? Because the baby boomer population is coming of age in Michigan. In fact, their consuming habits make just about every other age group look like a pack of misers. Just take a look how boomers 50 and over behave as a whole nationwide:

  • They account for 90 percent of all non-business travel
  • They purchase 43 percent of all cars
  • They own 77 percent of all assets in the United States
  • They vote more than anyone else

According to census data released this year, poverty among seniors nationally was about 23 percent lower than among the population as a whole. In fact, aging boomers represent the wealthiest consumer segment with the largest amount of discretionary income, compared to all other age groups.

Almost all have some form of health insurance through Medicare or some form of legacy workplace retirement programs — so they’re not a big drag on state and local budgets. They rarely go to jail, so they don’t eat away at that big billion-dollar budget item, either.

So, we have the only growing Michigan population spending the most amount of money and using the least amount of state taxes. Maybe boomers/seniors should be added to the urgent economic-development priority list. Perhaps we’ve been taking aging boomers for granted. The evidence is certainly there. According to the most recent benchmarking study, about $1.3 billion dollars is taken from the Michigan economy every year due to the out-migration of seniors. That’s the fifth worst senior out-migration trend in the nation.

Many people think that number is inevitable — that seniors out-migrate from Michigan simply because of the weather or because they’re following their adult children as their kids out-migrate. Some of that reasoning is true, but it may be oversold. Take a look at Traverse City, which makes metro Detroit seem balmy in the winter, and you’ll find a story that flies in the face of that assumption.

A number of years ago, Traverse City business and community leaders set out to transform its sluggish economy into one fundamentally based on a senior residential and recreational vitality. What’s more, U.S. News & World Report recently cited Ann Arbor as one of top 10 best places to retire.

Metro Detroit should go to school on what they did — or at least embrace the idea that some of that $1.3 billion doesn’t have to leave the state every year. Just follow the money and focus on the low hanging fruit.

Seniors are already here. They have money. They’re a tax profit center. Now we need to earn their loyalty with an economic-development plan that focuses on senior-friendly communities, mass transportation, and “green” residential properties.

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