November
2007

 

By
Larry DeBoer
 
Professor of
Agricultural Economics
Purdue University

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11-21-07

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The Economy's Other Hands


On the one hand, the economy might do just fine. On the other hand, maybe it won't. Now is a particularly good time for that phrase, "On the other hand." Most data shows that the economy is growing. But there are enough questions, issues and threats to fill several "other hands."

On the one hand, output is rising. Real gross domestic product grew handily at a 4 percent annual rate over the six months from April to September. That's the production of goods and services, adjusted for inflation, our broadest measure of what's happening. The unemployment rate remains under 5 percent, though it's been edging upward since spring. Inflation bounces up and down with energy prices. Easier to read is the "core rate" of inflation, which ignores energy and food. It's dropped almost a percentage point in the past year, from nearly 3 percent to nearly 2 percent.

On the other hand, housing construction has collapsed. Real residential investment grew hand over fist, 8 percent a year, from the end of 2001 to the end of 2005. Since then it's fallen 14 percent per year. There's no end in sight. Building permits are an indicator of future housing construction, since builders have to get a permit a few weeks or months before they build. Permits are down 17 percent in just the past four months. Housing construction isn't going to grow any time soon.

The economy can handle a housing construction collapse. Residential investment is only 4 percent of total gross domestic product. The economy as a whole grew handsomely even as residential investment was plunging.

On the other hand, there's been a huge rise in mortgage defaults, especially on all those sub-prime mortgages. Investors in such mortgages aren't sure how much money they will lose. This makes them skittish, and that can cause a "credit crunch." When that happens, borrowers can't get funds for new buildings and equipment. Consumers can't get funds for houses, cars and furniture. Lenders hand money to only the safest borrowers.

The very safest borrower is the U.S. Treasury, which hasn't missed an interest payment in 218 years. If there's a credit crunch, money flows to the Treasury and away from business borrowers. That cuts the interest rate that the Treasury pays and increases the rate that businesses pay. That's happening. The spread between the short-term Treasury interest rate and the short-term commercial rate has topped 1 percent for the past four months. The last time it got that high was October 1999, right before the last recession.

The credit crunch hasn't affected business investment spending yet. Real spending on business buildings and equipment is growing just a little slower than it was earlier in this expansion.

On the other hand, consumers may quit spending. How consumers react to the housing collapse and the credit crunch may be the most important question, because consumption spending is more than two-thirds of gross domestic product. If consumers spend less, GDP will drop.

The big increases in home values supported a lot of new home equity loans, which added to consumer spending. With home values dropping and lenders reluctant, consumers may borrow and spend less.

So far they're holding up. During the past year, real consumer spending grew at pretty much the same rate as in past years. Consumers are doing some hand wringing, though. When asked, they say they're not as optimistic as they were a year ago. The index of consumer sentiment is down 14 percent in the past year.

The Federal Reserve has tried to address these problems with two recent interest rate cuts, but the Fed has its own two-handed problem. On the one hand, production may slow down, and unemployment may rise. That would call for more interest rate cuts. On the other hand, oil prices are rising, and the value of the dollar is falling. That could increase inflation, and that would call for interest rate hikes.

On the one hand, the economy is growing. On the other hand, there's an on-going housing collapse, a credit crunch, less-optimistic consumers, oil price hikes and a falling dollar. Harry Truman once famously asked for a one-handed economist. Today, he'd be lucky to find one with less than six.

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Writer: Larry DeBoer
Editor: Olivia Maddox