A Hard Fall

December 30, 2009

By Dick Conway


downarrowThe Washington state economy will build steam through the spring and summer of 2010, but total employment won’t return to peak levels of 2008 until well into 2011, analysts forecast. And for many residents and businesses, the gloomy outlook will persist. “Economists say they see a recovery, but try to tell that to the 7 or 8 million people [nationwide] without jobs,” says Costco CEO Jim Sinegal.

The good news is that Washington is still in better shape than the national economy. “Our highest wage sectors, aerospace and software publishing, are relatively stable and that has helped,” notes Washington state economist Arun Raha. Phyllis Campbell, chair of JPMorgan Chase, Washington, says she is “cautiously optimistic” about the future because of the region’s many entrepreneurial companies and its exposure to international trade at a time when Asian economies are returning to health.

But there are still plenty of industries in a world of hurt. Weak consumer spending continues to hurt the retail sector. Also troubling are problems in the real estate sector where the inventory of homes remains uncomfortably high. “We see a particularly significant oversupply among higher-priced houses,” explains Glenn Crellin, director of the Washington Center for Real Estate Research. The commercial real estate market is in even worse shape as vacancy rates continue to rise. That situation will reduce the number of jobs in the construction sector in 2010 to 150,000, down sharply from 208,000 in 2007. Raha worries that regional banks’ exposure to bad loans in the construction sector will force them to raise reserves, making less credit available to businesses in the state. Here Seattle economist Dick Conway looks at what took us into the current recession and what we have to look forward to in the coming year.

How Did We Get Here?

Forecasting recessions is not a strong suit of the economics profession. There is the stale joke about the economist who predicted six of the last two downturns. And the cartoon of an economist hip deep in a hole declaring that there would be no recession.

Why do economists have trouble predicting recessions? For one thing, there has been little opportunity to practice the art. The Puget Sound region has suffered only four major slumps in the past forty years.

Recessions are also idiosyncratic. Thus, past downturns leave few clues about the timing and nature of future setbacks. The Boeing Bust (1969-71) was nothing like the Dot-com/9-11 Debacle (2001-03), except that both involved the airplane maker.

In 1969, after a decade of rapid growth in air travel spurred by the introduction of jet transports, the airplane market collapsed during an otherwise unremarkable national recession. Boeing went 17 months without a single sale to U.S. airlines and ended up nearly bankrupt. Left with no other option, the company eliminated 64,000 jobs in King and Snohomish counties. Altogether, the region lost 12.4 percent of its employment-one out of every eight jobs-causing the unemployment rate to soar to 12.2 percent. The Boeing Bust still stands as the region’s worst recession since the Great Depression.

The demise of the high-flying dot-coms, which triggered the 2001-03 recession, was in a sense less shocking. The crazy quilt of dot-com businesses combined with rampant speculation in high-tech stocks was a clear sign that the party would not last. Were it not for the Sept. 11 terrorist attacks, the local economy would have experienced a relatively minor disruption. But the financial damage to the airline industry inflicted by 9/11 ultimately led to the loss of 26,000 aerospace jobs here. During the 10-quarter slide, Puget Sound employment fell 4.8 percent.

Frankly, the current recession, caused by the collapse of the housing and credit markets, has been an embarrassment to economists. Not only should we have seen it coming-we have experienced housing bubbles before-but also, it should not have happened in the first place.

The chief culprit was subprime lending, a deadly form of speculation. But the real error of our ways was that weeconomists, lenders, homebuyers, investors and policymakersallowed a major part of our economy to become opaque. We neglected a basic tenet of a market economy: both buyers and sellers should have “perfect information.” That is, economic transactions should be transparent to all affected parties. When we lack transparency, we open ourselves up to Ponzi schemes and the financial shenanigans associated with subprime lending. More importantly, we place our economy in jeopardy.

The recession started when a speculative housing bubble burst, precipitating a rare decline in home prices. This bubble had been fueled by subprime loans, most of which were packaged into mortgage-backed securities. As mortgage defaults soared, trade in these securities came to a standstill-not even bond raters could figure out their value-which ultimately led to a credit freeze.

Ripple effects of the collapse of the housing and credit markets quickly spread to the real economy. Severely restricted mortgage lending and plunging home prices resulted in record low rates of homebuilding and the loss of nearly two million construction jobs nationally. Tight credit, falling home values, a 50 percent drop in the stock market and rising unemployment caused consumers to become tight-fisted, pushing automakers to the brink of bankruptcy. A weakening world economy, coupled with a strengthening dollar, precipitated a downturn in foreign exports. And a steep fall-off in tax revenue gave rise to unprecedented budget deficits for state and local governments.

employment graphAttesting to the severity and potential danger of the recession, virtually every corner of the national economyevery state and every industry with few exceptionsfelt its harmful impact. Initially, it appeared that if any part of the country could cope with the downturn it was the Northwest. Leading up to the recession, regional employment and population were growing at twice the national rate.

But the momentum of the Puget Sound economy could not forestall a disastrous housing crash. Since the peak of the housing market, regional home sales have fallen 55 percent, residential building permits have dropped 71 percent and home prices have declined 16 percent. This situation, in turn, has led to widespread damage in the economy, including the loss of 27,000 construction jobs, the failure of Washington Mutual Bank, layoffs at Boeing and Microsoft, and an 18 percent plunge in taxable retail sales.

By the third quarter of 2009, the recession had cost the area 97,000 jobs or 5.3 percent of its total employment, driving up the unemployment rate to 9.0 percent. Following a 4.9 percent employment loss, the American jobless rate stood at 9.6 percent in the third quarter.

Even as the job situation continued to deteriorate in the summer, signs of a national recovery began to emerge. It appeared that the prodigious effort by the federal government to right the economylowering interest rates, infusing capital into financial institutions, guaranteeing loans and providing fiscal stimulus-was about to pay off. Four tracking indicatorsthe Economic Cycle Research Institute (ECRI) leading index, the stock market, the LIBOR rate and home prices-gave reason for renewed hope.

The weekly leading index developed by the ECRI comprises seven forward-looking indicators. For the past several months, it has been pointing to a “stronger U.S. economic recovery than most anticipate.”

From its March low, the stock market has rebounded about 60 percent, a hearty endorsement by investors that business conditions are improving. An upturn in the market should also help put jittery consumers at ease.

The difference between the three-month London Interbank Offered Rate (LIBOR) and the three-month T-bill rate is a measure of credit availability. After widening to more than 400 basis points (4 percentage points) during the credit freeze, the spread has narrowed to less than 30 basis points, a more normal difference. This change does not mean that the credit markets have completely thawed, but they are getting close.

The most important development has been the turnaround in American home prices. It has been clear from the outset of the recession that nothing good would happen to the economy until home prices stabilized. Between May and August, national home prices rose 3.0 percent, the first gain in three years, according to the Case-Shiller price index. The fall in prices was halted by a spurt of sales brought about by the increased affordability of homes and the $8,000 new homebuyer tax credit.

In October, the U.S. Bureau of Economic Analysis, which maintains the national income and product accounts, reported the first solid evidence of the recovery. After a string of four quarterly losses, real Gross Domestic Product (GDP) grew at a 3.5 percent annual rate in the third quarter of 2009.

According to employment data, the Northwest has trailed the nation by about one quarter throughout the recession. Thus, signs of a Puget Sound recovery are still mixed. Nevertheless, there is evidence that the area economy is also laying the groundwork for growth.

The region is still shedding jobs but at a slowing rate. In the last quarter of 2008, employment fell at a 6.7 percent annual rate. In the third quarter of 2009, the rate of decline was down to 2.9 percent.

Like its national counterpart, the Puget Sound housing market has apparently bottomed out. In response to an upturn in home sales, the seasonally-adjusted average home price has been bouncing around $350,000 since March, according to Northwest Multiple Listing Service data.

leadingindexThe latest reading of the Puget Sound Index of Leading Economic Indicators has provided perhaps the most promising sign that a local recovery is on the way. Composed of seven variables-including, for example, regional housing permits and the Boeing backlog-delivery ratio-it tends to lead the Puget Sound business cycle by three to six quarters. After a steep eight-quarter slide, the leading index suddenly reversed course and pointed up in the third quarter of 2009.

Regional recovery is likely to be a drawn-out affair, especially with regard to employment, according to the latest Puget Sound economic forecast. Not until the second quarter of 2010 will employment begin to rise, not until 2013 will it return to its 2008 peak and not until 2016 will the unemployment rate drop to 6 percent.

There are two reasons for the slow recovery. Problems in the housing and credit markets will take time to fully unwind. And, despite a relatively strong export sector, neither Boeing nor Microsoft will be a significant growth force.

The Puget Sound economy will improve in 2010, but progress must be judged in relative terms. After falling 4.0 percent in 2009, employment will decline only 0.8 percent in 2010. Current-dollar personal income will increase 3.2 percent, following a 1.8 percent loss in the previous year. Because of the weak economy, the inflation rate is predicted to be only 1.7 percent.

In 2011, as the recovery catches hold, the regional economy will grow at a healthier rate. In general, 2011 is setting up to be a reasonably good year: a 1.8 percent increase in employment, a 4.7 percent gain in personal income, a 1.8 percent inflation rate and a 31.4 percent jump in housing permits.

Before turning to the long-term outlook, here is a trivia question. How many jobs will the United States create in the first decade of the 21st century? The answer is zero or close to it. The Puget Sound region will hardly do better, adding just 35,000 jobs during the 10-year period. By comparison, 350,000 jobs were created here between 1990 and 2000. Hammered by the dot-com implosion, 9/11, the housing bubble and credit crunch, and soaring energy prices, the current decade will go down as the Dismal Decade.

up arrowWill the next decade be any kinder? The answer is almost certainly yes, as the national and regional economies will have an opportunity to play a game of catch-up. Given the nation’s rapidly aging population, the projected annual trend (full-employment) growth rates for employment and real GDP are 0.6 percent and 2.2 percent, respectively. But the national economy should be able to take advantage of the labor supplied by the 15 million plus people left unemployed by the current recession. Thus, the actual employment growth rate will likely be closer to 1.3 percent between 2010 and 2020. This figure would imply a real GDP growth rate of 2.8 percent, up substantially from the 1.7 percent rate during the current decade.

Barring a major move by Boeing to South Carolina-one that would take more than the 3,800 jobs already announced-the Puget Sound area should continue to grow faster than the nation. There are five reasons for this optimistic prognosis: the location in one of the fastest growing parts of the country; the ability to sell goods and services in foreign markets; the world-class companies; a high concentration of high-tech activities; and natural and cultural amenities that make the Northwest an attractive place to live and locate a business.

Specifically, I predict that employment will grow at a 1.8 percent annual rate between 2010 and 2020. As a consequence, the area comprising King, Snohomish, Kitsap and Pierce Counties will create a total of 350,000 jobs, ten times the number than during the current decade. By 2020, the Puget Sound region will have nearly 4.1 million residents with 2.1 million jobs and $301 billion in personal income.

Dick Conway is a Seattle economist and co-publisher of The Puget Sound Economic Forecaster.