This is Not the End of America_February 2009

8/14/2019 This is Not the End of America_February 2009

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This report is available on www.wachovia.com/economics and on Bloomberg at WBEC

SPECIAL COMMENTARY February 23, 2

This Is Not the End of America

Mark Vitner, Senior Econommark.vitner@wachovia

1-704-383-

Throughout this financial crisis, I have been approached repeatedly by people fromall walks of life asking the question, Is this the end of America as we know it? Is

the American Dream dead? Are we finally at the point where our nation and itseconomy have begun a downward spiral that will end the hegemony the UnitedStates has enjoyed since World War II? And if so, how will that affect the standard ofliving for the vast majority of Americans?

The current recessionshares a great manysimilarities with the1973-75 and 1981-82downturns, so the hit toconsumer confidenceand the nations psycheare understandable.

I am 46 years old and this is at least the third bout of self-confidence we have seenour nation struggle with. Both of those earlier struggles coincided with relativelylong and deep recessions, 1973-75 and 1981-82. The current recession shares a greatmany similarities with those earlier downturns. In fact, we would go as far to saythat the current recession incorporates the worst qualities of the two deepest priorpostwar recessions. Given this scenario, the hit to consumer confidence and thenations psyche are understandable.

Not only were those two earlier downturns the longest and deepest recessions in thepostwar period, but both were also transformational events that dramaticallychanged the way our economy has operated since. What drove economic growthprior to the recession essentially got hammered in the downturn, and the economiclandscape looked vastly different in the ensuing recovery. Fear of the unknown ispalatable, and the unknowns today are many.

Recessions areessentially caused byexcesses that build upduring the boom times,which cause capital tobe misallocated.

The purpose of this essay is to show that todays economic troubles did not occur inisolation. Our nation has faced similar challenges before and overcome them. Howwe overcame those earlier downturns has important implications for policymakersand business leaders today. Recessions are essentially caused by excesses that buildup during the boom times, which cause capital to be misallocated. These imbalancesare ultimately brought into check by a reduction in risk tolerances. The reduction in

risk tolerances is typically brought about by some key policy change or externalshock, which causes businesses, consumers, investors and regulators to become morecautious.

Most postwar recessions were ended by aggressive monetary easing and fiscal policyexpansion. Monetary policy has been the more effective tool in recent cycles, as fiscalpolicy has been too slow.1 Moreover, persistently large federal budget deficits have

1 Romer, Christina D. and Romer, David H., What Ends Recessions? (1994-06-01). NBER Working PaperNo. W476
mailto:[email protected]:[email protected]


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This Is Not the End of AmericaFebruary 23, 2009 SPECIAL COMMENTARY

tended to constrain fiscal policy alternatives in recent years, with actions being toosmall to make a meaningful change.

Some of theseimbalances, such as low

productivity growthand the persistent lackof national saving, wererolled over into the nextbusiness cycle, wherethey continued to buildand eventually evolvedinto the monumentalcredit bubble we aredealing with today.

While policy intervention has been successful at reversing the downward trend ineconomic activity, it has rarely done anything to reverse the underlying long-run

imbalances that brought about the recession itself. Some of these imbalances, such aslow productivity growth and the persistent lack of national saving, were rolled overinto the next business cycle, where they continued to build and eventually evolvedinto the monumental credit bubble we are dealing with today. Fully unwindingthese imbalances will require significant policy actions on both the monetary andfiscal fronts and will ultimately take several years to complete.

Recessions Are Caused by Imbalances and Policy MistakesRecessions are essentially caused by the intersection of imbalances that build upduring the boom years and some sort of exogenous shock or policy mistake. Back inthe 1970s and the early 1980s, imbalances were concentrated in the nations industrialheartland where cheap and abundant energy allowed much of American industry toprosper, even against a rising tide of overseas competition, particularly from Japan

and other emerging economies. In addition, the early 1970s saw a tremendoushousing boom, as consumers rushed into the only meaningful inflation hedgeavailable. These imbalances were ultimately brought into check by a pair of oilshocks and sharply higher interest rates, which dramatically transformed thecompetitive landscape and ushered in a credit crunch like none other seen since theGreat Depression.

History Has Lessons for Todays EconomyThe most definingcharacteristic of the1973-75 recession isthat it marked the endof the era of cheap and

abundant energy.

The most defining characteristic of the 1973-75 recession is that it marked the end ofthe era of cheap and abundant energy. Prior to 1973, oil prices averaged around $2 -$3 a barrel for the previous 20 years. Low energy prices provided little incentive tofind ways to use energy more efficiently. Entire industrial processes were builtaround the premise that energy would remain cheap and abundant. Buildings,homes and automobiles were built more for comfort and convenience than energyefficiency.

Low energy prices also helped sow the seeds of the housing boom and bust of theearly 1970s. The persistence of low oil prices allowed monetary and fiscal policies tobe far looser than they otherwise would have been, particularly at a time when bothwere stretched to the max by the twin burdens of the Vietnam War and Great Societyprograms. Inflation became problematic in the late 1960s and briefly reached sixpercent. Higher inflation led to a weakening in confidence in the dollar and theultimate breakdown of the Bretton Woods monetary system. President Nixon endedthe final link to the gold standard in 1971 and later that year imposed wage and pricecontrols.

The problematic inflation of the late 1960s and early 1970s drove up demand for hardassets. Gold could not be purchased privately back then, and interest on savingsaccounts were limited by law. Consumers turned to the next best alternative, realestate. Sales of homes surged during the 1969 to 1973 period and home pricesincreased substantially both in nominal and real terms as an increasing share of thenations resources were allocated to housing.

2


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Figure 1

Existing Single-Family Home SalesThousands of Units, SAAR

1,000

2,000

3,000

4,000

5,000

6,000

7,000

1968 1973 1978 1983 1988 1993 1998 2003 2008

1,000

2,000

3,000

4,000

5,000

6,000

7,000

Existing Home Sales: Dec @ 4,260

Figure 2

Crude OilDollars per Barrel

$0

$20

$40

$60

$80

$100

$120

$140

1965 1970 1975 1980 1985 1990 1995 2000 2005

$0

$20

$40

$60

$80

$100

$120

$140

WTI Spot Price: Jan @ $41.74

Source: National Association of Realtors, Federal Reserve Bank of St. Louis and Wachovia

When oil prices did rise, they did so with enormous authority - essentiallyquadrupling in a matter of weeks. In late 1973, an embargo by many Arabianproducers led to long gas lines throughout much of the country, which ushered in an

era of vulnerability and set off a mad rush to boost energy efficiency. Consumerconfidence plummeted 53 points between October 1973 and February 1974 and theeconomy fell into a deep and prolonged recession.

The resulting correction disproportionately impacted areas where imbalances haddeveloped. Anything dependent on cheap and abundant energy got crushed in thisdownturn. Much of American industry suddenly found itself at a comparativedisadvantage with Japanese firms, which had been forced to become more energyefficient much earlier as that nation imports practically all the petroleum it uses. Theoil shock dramatically impacted the competitive landscape. U.S. nonfarmproductivity growth, which had grown at an average pace of 2.7 percent per yearduring the two decades prior to 1973, slowed to just a 1.4 percent pace during thesubsequent 22 years.

Productivity growth, or output per hour, is the ticket to higher living standards.With productivity growing at 2.7 percent per year, living standards double every 25years, but at 1.4 percent per year, living standards would take more than 50 years todouble. Put differently, slower productivity growth meant companies could notafford to boost wages as rapidly as they had earlier, which ushered in an extendedera of minimal real wage growth. Moreover, parts of the country where wage rateswere less flexible, such as vast portions of the Midwest and the Northeast, saw largeportions of their industrial base close down or migrate to regions with lower laborcosts.

Not only did efficiency take a hit from the energy shock, but entire industries soonfound they needed to quickly change their product mix. Nowhere was this more

evident than in the American automobile industry, which suddenly found itselfproducing the wrong products for this new era. The travel and leisure industry wasanother casualty. Florida vacation destinations, which then saw the vast majority oftheir visitors arrive by car, were devastated as consumers rightly worried not onlyabout the price of gasoline but also the very availability of it.

Anything dependent oncheap and abundantenergy got crushed inthe 1973-75 recession.

Slower productivitygrowth meantcompanies could notafford to boost wagesas rapidly as they hadearlier.


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4

Figure 3

Productivity - Total NonfarmYear-over-Year Percent Change, 3-Year Moving Average

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

60 65 70 75 80 85 90 95 00 05

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

Nonfarm Productivity: Q4 @ 1.8%

Dashed Line - Long-Run Average 1950-2008: 2.2%

Source: Federal Reserve Board and Wachovia

The surge in energy prices in late 1973 and early 1974 also caused interest rates tospike and choked off capital to the housing industry. Back then, interest rates onbank deposits were set by statute and higher inflation and rising market interest ratesessentially shut down mortgage lending. Lending itself was dependent on bank

deposits, as there were no mortgage-backed securities back then. Sales of new andexisting homes were already weakening but soon plummeted. As that credit crunchworsened, homebuilding and commercial construction both slumped to theirweakest levels in decades.

At the time, the 1973-75 recession was the worst seen since the Great Depression.The downturn lasted 16 months and only ended after aggressive easing on the partof the Federal Reserve. Moreover, the ensuing recovery was exceptionallytreacherous. Unemployment and inflation remained relatively high throughoutmuch of the rest of the 1970s, a condition that was subsequently labeledStagflation.

The Eighties Started with Back-to-Back Recessions

It took another couple of recessions in the early 1980s to finally cleanse the system ofinflationary pressures built up in the 1970s. The first was an extremely sharp butbrief downturn, which lasted just six months. The 1980s recession was primarily byPresident Carters attempt to rein in inflation by imposing credit controls. The primerate shot up to 20 percent and consumers soon found themselves shut out of thecredit markets, as usury laws made consumer lending unprofitable in many states. 2

2 Owens, Raymond E. & Schreft, Stacey L. 1993. Identifying Credit Crunches. Working Paper 93-02,Federal Reserve Bank of Richmond.

At the time, the 1973-75recession was the worstseen since the Great

Depression.


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The only thing reined in, however, was growth. Consumer spending plummetedand the economy sank into a deep but exceptionally short downturn. Growthbounced back briefly once credit controls were lifted later that year.

One year after the 1980s recession ended, the economy slid into another long and

deep recession. This downturn would match the 1973-75 recession in length, as thelongest on record, but turned out to be far deeper. The unemployment rate toppedout at a whopping 10.8 percent in late 1982. Midwest manufacturers took a huge hit,as inefficiencies brought to light by the energy crunch drove many companies to thebreaking point. There was a huge out-migration of labor and capital from theMidwest Rust Belt to Texas, Florida and other parts of the Sunbelt.

Figure 4

U.S. Consumer Price IndexYear-over-Year Percent Change

0%

2%

4%

6%

8%

10%

12%

14%

16%

60 64 68 72 76 80 84 88 92 96 00 04 08

0%

2%

4%

6%

8%

10%

12%

14%

16%

CPI: Dec @ 0.1%

Figure 5

Unemployment and Wage RatesSeasonally Adjusted

0%

2%

4%

6%

8%

10%

12%

60 65 70 75 80 85 90 95 00 05

0%

2%

4%

6%

8%

10%

12%

Unemployment Rate: Jan @ 7.6%

Hourly Earnings: Jan @ 3.9%

Source: U.S. Department of Labor and Wachovia

The 1981-82 recession finally ended when, after breaking the back of inflation,monetary policy eased up a bit. The prime rate fell from 20 percent at the start of therecession in mid-1981 to around 11.5 percent when the recession ended in late 1982.Lower short-term interest rates along with massive tax cuts and increased defense

outlays soon spurred a remarkable economic recovery that would eclipse anythingseen previously in the postwar era. The expansion lasted a postwar-record 92months. More than 21 million jobs were added to nonfarm payrolls and before itended, the expansion saw the unemployment rate fall to 5.2 percent. Even moresurprising, the drop in unemployment occurred without an accompanying spike ininflation.

While the 1980s saw an enormous economic boom, the period was clearly not devoidof drama and controversy. The combination of an abrupt fall in inflation, sharplylower marginal tax rates and hefty increases in defense and social spending led tomassive federal budget deficits. The federal budget deficit peaked at 6.0 percent ofGDP in 1983. By the tail end of the 1980s, however, the deficit had shrunk to a moremanageable 2.8 percent of GDP.3

The 1980s also saw the start of a massive bull market in equities, which had beenlargely moribund since 1973. The Dow Jones Industrial Average rose 254 percentfrom its August 1982 low of 777 and ended the decade at around 2,750, even afterenduring one of its worst crashes ever in October 1987. Of course, the 1980s also sawthe end of the Cold War, with the Berlin Wall coming down in 1989.

3Economic Report of the President, 2009. Table B-79. Federal receipts, outlays, surplus of deficit, and debt, aspercent of gross domestic product, fiscal years 1934-2009

The 1981-82 recessionfinally ended when,after breaking the backof inflation, monetary

policy eased up a bit.


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A Short and Shallow Recession Greets the NinetiesThe long 1980s expansion came to end shortly after Saddam Hussein invaded Kuwaitin August 1990 and oil prices spiked. The 1990-91 recession was one of the shorteston record, lasting just eight months, and ended in March 1991. With so little

downtime, many of the excesses built up during the boom times did not haveenough time to completely unwind.

A long expansion tends to create a lot of excesses. Virtually anything that boomed inthe 1980s got crushed during the 1990-91 downturn and the two to three yearsafterward. One prominent area that boomed and busted was the defense sector,where the sudden and unexpected end of the Cold War brought the defense build-upto an abrupt halt. Household, corporate, and government debt also got out ofbalance, as new credit vehicles such as junk bonds and excessive lending by thrifts,led to a credit bubble.

Easy credit caused residential and commercial construction to become massivelyoverbuilt. When credit dried up in the late 1980s, there was a huge slump inresidential and commercial real estate, which was certainly troublesome but nowhere

near as bad as was seen back in the early 1970s. Still, there were bank failures andseveral regions suffered greatly, including Florida, California and the Northeast.

One of the unusual aspects of the Eighties period was that it saw a series of rollingrecessions move through the Midwest, the energy sector, New England, Florida andCalifornia. Some of these downturns overlapped, but others occurred in isolation.At the end of the decade it was clearly Californias turn. Defense cutbacks and thereal estate slump weighed heavily on the Golden State. In addition, regulators weredealing with the aftermath of the Savings & Loan crisis; a problem itself that hadbeen gestating for more than a decade.

While the recession was short-lived, the hangover from excesses built up from the1980s resulted in an unusually slow economic recovery that was partially offset by

dramatically lower interest rates. The 1990-91 recession began with the federal fundsrate at around 8 percent and ended with the funds rate around 6 percent. The lack ofa strong economic recovery or upturn in employment eventually prodded theFederal Reserve to cut the federal funds rate to a then unimaginable three percent,where it subsequently held the rate there for 17 months.

While the ensuing expansion took some time to gain momentum, it subsequentlyexceeded the 1980s in length, lasting a record 120 months. Employment did notsurge like it did in the previous decade, but unemployment reached modern era lowsand the stock market surged in ways seldom seen before. 4 The evolution of theInternet and vast improvements in computer technology were the driving force forthe 1990s expansion, with the strongest gains occurring in the second half of thedecade.

The Dawn of the New EconomyWith so much growth coming from new technologies, for which the price was falling,the long 1990s expansion seemed to defy economic logic. Growth boomed andinflation moderated. Productivity growth surged during the late 1990s, but little ofthis gain filtered through to workers. Real wage growth did not improve anywherenear as much as productivity did. As a result, many of the best known researchers

4 The 1990s produced a net gain of 21 million jobs over 10 years, while the 1980s expansion added thatsame number of jobs in just under eight years.

The lack of a strongeconomic recovery or

upturn in employmenteventually prodded the

Federal Reserve to cutthe federal funds rate toa then unimaginablethree percent.


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on productivity trends questioned the validity and sustainability of the upturn inproductivity growth.5

One huge beneficiary of the technology boom and strong economic growth of the late1990s was the stock market. The Dow Jones Industrial Average began to rally in

November 1994 and topped out in April 2000 at 11,723, representing a whoppinggain of 219 percent. Stock market appreciation sent capital gains tax receipts soaringwhich, combined with stronger economic growth, eventually led to a short period offederal budget surpluses.

The stock market bubble eventually burst and set the economy on course for arecession that began in March 2001 and ended just eight months later. Just as in therecession a decade earlier, the short and shallow downturn did not allow much timeto correct the imbalances built up during the boom years. Those imbalances werelargely in the technology sector, which saw massive overinvestment in computertechnology, network infrastructure, and telecommunications systems. As a result,these sectors continued to languish well after the recession officially ended.

Two Long Booms but How Much Better Off Were American Households?The 1980s and 1990s saw a combined 212 months of expansion interrupted by justeight months of recession, a period of prosperity never before seen in U.S. history.Beneath the surface, however, there were still some major unresolved issues. Realaverage hourly earnings were essentially unchanged from September 1973 toSeptember 2000, rising from $7.95 to $8.03.

Compensation trends changed greatly over this time period, however, with a farsmaller proportion of the overall workforce paid by the hour. In addition, profitsharing, bonus payments, and fringe benefits began to make up a much largerproportion of overall compensation during this time period. That said, even morecomprehensive measures of living standards, such as inflation-adjusted per capitaincome, rose much more slowly. Real per capita income rose at a 3.4 percent pace

from September 1959 to September 1973 but increased at just a 1.9 percent annualrate from 1973 to the end of the century. The comparable numbers for nonfarmproductivity growth for those periods were 2.7 percent per year from 1959 to 1973,and 1.6 percent a year for 1973 to 2000. While that is not a perfect fit, the correlationseems overtly obvious. Businesses cannot continuously boost wages faster thanproductivity rises without driving themselves out of business.

The slowdown in per capita growth coincided with a sustained rise in the costs ofbasic necessities. Consumer spending for food, energy, housing and healthcare hassteadily eaten up a larger share of household budgets. By mid-2008, approximately57 cents out of every dollar consumers spent went for these four basic necessities,which meant that consumers were spending more on things they had to buy and lesson things they wanted to buy.

Households initially coped with the lack of income growth and purchasing power bysending their spouses to work and taking on more debt. The percentage of women inthe workforce rose from 45 percent in 1973 to 60 percent by the end of the century.

5 Gordon, Robert J., The 1920s and the 1990s in Mutual Reflection (November 2005). NBER Working PaperNo. W11778.

roductivity growthsurged during the late

1990s, but little of thisgain filtered through toworkers.

Businesses cannotcontinuously boostwages faster than

productivity riseswithout drivingthemselves out of

business.


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8

Even more telling is that after 1993, most of the increase in womens labor forceparticipation occurred among mothers.6

When two incomes could no longer make ends meet, households put their house towork, by tapping the equity in their home. Household debt amounted to just above

56 percent of after-tax income back in 1973 but rose to 90 percent by the end of thecentury and 126 percent by late 2007. The logic behind taking on so much debt wasthat incomes would continue to increase, housing prices would continue to rise orsome other assets would appreciate so consumer could service and ultimately retirethis debt.

Figure 6

Household DebtAs a Percent of Disposable Personal Income

40%

60%

80%

100%

120%

140%

60 65 70 75 80 85 90 95 00 05

40%

60%

80%

100%

120%

140%

Debt as % of Disposable Personal Income: Q3 @ 123.2%

Figure 7

Domestic Nonfinancial DebtAs Percent Of GDP

125%

150%

175%

200%

225%

250%

82 84 86 88 90 92 94 96 98 00 02 04 06 08

125%

150%

175%

200%

225%

250%

Nonfinancial Debt: Q3 @ 228.4%

Source: Federal Reserve Board, U.S. Department of Commerce and Wachovia

Everything in Life Is a RerunSo how will the economy evolve through the current recession? The answer can befound by examining where the excesses were created leading up to the downturnand what events caused investors, businesses, regulators and consumers to becomeless risk tolerant. Where was capital misallocated? Many of the answers are quite

obvious. Anything dependent on cheap and abundant credit boomed during thefirst half of this decade. Housing is the most obvious excess, with home sales andhousing prices soaring to unprecedented heights. But housing was not the onlyproblem area. Credit of all types boomed, as innovative financial products outranthe regulators ability to regulate them. Risks throughout the economy and financialsystem were enormously under-priced.

The recession put an abrupt end to excessive credit growth. The appetite for riskbegan to contract when the median price of an existing home began falling on a year-to-year basis back in August 2006. Once housing prices started falling it did not takelong before many mortgage providers found themselves in trouble and risk aversiongrew as every big name mortgage provider shut down.

The principal event that shifted attitudes about risk, however, was the August 9, 2007

announcement by BNP Paribas that it would halt the redemption of three of its fundsthat had investments in securities tied to subprime mortgages. The reason cited forthe halt in redemptions was that the underlying collateral in these funds could not bevalued. The halt in redemptions sent shudders throughout the financial markets,effectively shutting down the securitization business. Confidence continued to erodeas numerous mortgage lenders shut down, eventually resulting in the greatest shake-

6 Hayghe, Howard V., Developments in womens labor force participation. Monthly Labor Review.September 1997, Volume 120, Number 9. page 42

Anything dependentupon cheap andabundant creditboomed during the firsthalf of this decade, ascapital flowed into thatsector.


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up in the financial services sector since the 1930s. As we saw a generation earlierwith the first oil shock, this recession became a major transformational event. Just asthe 1973-75 recession marked the end of the era of cheap and abundant energy, thehallmark of this downturn is that it marks the end of the era of easy and abundantcredit.

Figure 8

Home Ownership RatePercent of Households

62.0%

63.0%

64.0%

65.0%

66.0%

67.0%

68.0%

69.0%

70.0%

1965 1970 1975 1980 1985 1990 1995 2000 2005

62.0%

63.0%

64.0%

65.0%

66.0%

67.0%

68.0%

69.0%

70.0%

Home Ownership Rate: Q4 @ 67.5%

Figure 9

Mortgage Equity WithdrawalBillions of Dollars

-$20

$0

$20

$40

$60

$80

$100

$120

$140

$160

1992 1994 1996 1998 2000 2002 2004 2006 2008

-$20

$0

$20

$40

$60

$80

$100

$120

$140

$160

Mortgage Equity Withdrawal: Q3 @ -$0.7 B

Source: Federal Reserve Board, U.S. Department of Commerce and Wachovia

The combination of easy and abundant credit along with the lowest interest rates in ageneration helped fuel an unprecedented boom in housing and all things tied to it.Sales of new and existing homes surged during the first half of this decade. Sales ofnew homes rose nearly 45 percent between 1998 and 2005, when they peaked at 1.283million units. Sales of existing homes hit a record 6.34 million-unit pace inSeptember 2005. After remaining near 64 percent for 15 years or more, thehomeownership rate surged nearly five percentage points between 1995 and early2005, reaching a record 69.2 percent in the first quarter of that year. And, as weknow all too well, the value of homes surged 88.5 percent between 2001 and 2006.

When the housing boom finally came undone not only did home sales, housingconstruction and home prices plummet but anything remotely tied to housing alsogot pummeled. The housing boom led to a massive misallocation of resources, ascapital poured into everything tied to housing. Not only did we end up with twomillion more homes than we needed, but we also had way too many homebuilders,way too many mortgage lenders, way too many Realtors and too many appraisers,home inspectors and closing attorneys. And this was only the direct impact.

Indirectly, we now know the housing boom also drove consumer spending in amajor way as homeowners increasingly tapped into the equity of their homes.Mortgage equity withdrawal began to rise back in 1996 but really began to take off in2001, once housing prices went into overdrive. Quarterly mortgage equitywithdrawals surged from $40 billion in 2001 to around $140 billion at the peak of the

housing cycle in mid-2006. All this extra cash fueled spending on cars, boats andhome improvements, which again caused capital to be monumentally misallocated.

ust as the 1973-75recession marked theend of the era of cheapand abundant energy,the hallmark of thisdownturn is that itmarks the end of the eraof easy and abundantcredit.

The housing boom ledto a massivemisallocation ofresources, as capital

poured into everythingtied to housing.


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Figure 10

Auto SalesMillions of Vehicles, SAAR

8

10

12

14

16

18

20

22

1992 1994 1996 1998 2000 2002 2004 2006 2008

8

10

12

14

16

18

20

22

Auto Sales: Jan @ 9.5 Million

While it was difficult tosee it at the top of thecycle, motor vehiclesales at a 17 million-unit annual rate werenot sustainable withoutthe influx of mortgageequity borrowing.

Source: U.S. Department of Commerce and Wachovia

While it was difficult to see it at the top of the cycle, motor vehicle sales at a 17million-unit annual rate were not sustainable without the influx of mortgage equityborrowing. That soon became apparent when motor vehicle sales tumbled rightalong with home sales and housing prices. The same scenario is playing out

throughout the retail sector, where overall spending was driven well above what theunderlying fundamentals could support. So once the housing boom ended, not onlydid we have way too many homes, Realtors and mortgage bankers, but we also hadtoo many car dealers, too much motor vehicle assembly capacity and far too manyretailers, shopping centers and all the necessary infrastructure that supports them.

The growing influence that mortgage equity withdrawal played on consumerspending meant consumers were spending more than they were earning. The savingrate plunged. As a result, the U.S. trade deficit surged to unsustainable proportions.The U.S. current account deficit grew to a record 6.2 percent of GDP in mid-2006,right about the time the housing boom peaked. Again, capital was beingmisallocated, but this time the imbalances spilled over international borders.Emerging economies boomed during much of the decade, as exports to U.S.consumers fueled explosive gains in China, Korea, Malaysia, Vietnam and elsewhere.Emerging economies flush with dollars also became huge buyers of U.S. Treasurynotes, agency paper and all types of structured products.

Once the U.S. housingboom ended it did nottake long for the effectsto show up in Asia.

Once the U.S. housing boom ended, it did not take long for the effects to show up inAsia. The overspending by U.S. consumers meant Japanese motor vehiclemanufacturers, Chinese electronics makers and Korean television manufacturers allwound up with way too much capacity. All have cut output and employmentsharply in recent months, and virtually all of these emerging markets have either

10


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seen economic growth stumble or fallen into deep recessions of their own. Economicgrowth in many of these nations has tumbled, with Japans real GDP plummeting ata 12.7 percent annual rate during the fourth quarter.

Figure 11

U.S. Current Account DeficitAs Percent of GDP, 4 Quarter Moving Average

-8%

-6%

-4%

-2%

0%

2%

60 64 68 72 76 80 84 88 92 96 00 04 08

-8%

-6%

-4%

-2%

0%

2%

Balance on Current Account: Q3 @ -4.8%

Source: U.S. Department of Commerce and Wachovia

The impact of declining international trade is also evident at and around the majorU.S. ports. Port traffic surged during the boom years and warehouse and industrialspace near major seaports was extremely difficult to come by. Port traffic near majorcontainer ports has plummeted in recent months. Container traffic through the Portof Los Angeles and the Port of Long Beach plunged late last year, with throughput atthe Port of Long Beach plummeting 25 percent year-to-year in December and trafficat the Port of Los Angeles tumbling 15 percent. The only major storage headache forports today is where to park all the unwanted imported automobiles. With saleslanguishing, dealers are in no shape to take delivery of new vehicles.

The final major imbalance was in the financial sector, which devised new ways tomeet rising demand for home mortgages and also service the needs of newlyincredibly flush foreign investors that were in search of higher yielding investments.

The net result was explosive growth in the financial services sector, particularlyanything tied to originating, servicing or securitizing home mortgages. The sametechnologies applied to the housing sector were put to work in other areas, however,leading to a generalized boom in finance. Earnings and employment in the industrysurged during the first half of the decade, as the financial services sector grew tonearly eight percent of the nations GDP. By mid-2007, the market capitalization offinancial services firms rose to a record 21 percent of the S&P 500.

Container trafficthrough the Port of Los

Angeles and the Port ofLong Beach plungedlate last year.


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Figure 12

Finance, Insurance, and Real Estate EmploymentYr/Yr Percent Change vs 3-Month Percent Change, Annual Rate

-8%

-6%

-4%

-2%

0%

2%

4%

6%

90 92 94 96 98 00 02 04 06 08

-8%

-6%

-4%

-2%

0%

2%

4%

6%

3-Month Annual Rate: Jan @ -5.5%

Year/Year Change: Jan @ -3.3%

Source: U.S. Department of Labor and Wachovia

Growth in the financial services sector was heavily concentrated in a handful ofmarkets, namely New York, Chicago, Charlotte, Boston, Irvine, California and SanFrancisco. Office markets in these areas experienced brisk demand and vacancy ratesdropped precipitously during the height of the boom, as bankers, brokers and

attorneys leased space. When the boom ended, employment was slashed in many ofthese markets and demand for commercial office space dwindled.

Todays Economy: A Living History, or is History Merely Repeating Itself?The previous expansioncreated an oversupplyof housing, severelyoverleveragedhouseholds, a hugetrade imbalance and abloated financial sector.

Clearly, this crisis does not mark the end of America. Our nation has dealt withsimilar challenges to what we face today without succumbing to another GreatDepression or some other dastardly outcome. We still have to answer the question ofwhat comes next. We are now in the midst of the deepest recession since the 1930s,and there are at least four major imbalances that need to play out, in our opinion.The previous expansion created an oversupply of housing, severely overleveragedhouseholds, a huge trade imbalance and a bloated financial sector; which saw thepace of innovation significantly outrun the regulators ability to regulate it. These

fours areas, and everything tied to them, are bearing the brunt of the downturn. Bothmonetary and fiscal policies will need to take actions to offset the dampening effectsthe unwinding of these unbalances places on the broader economy.

Lessons on how policymakers dealt with past recessions provide some clues as tohow we will navigate through the current environment. Monetary policy ultimatelyended virtually every recession during the postwar era and it will likely again play aprominent role in ending this downturn. The Federal Reserve has been remarkablyproactive since the financial crisis intensified in mid-September, driving the federalfunds rate down to nearly zero and adding liquidity to the economy through

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numerous targeted lending facilities, including the commercial paper and asset-backsecurity markets. The monetary base has surged since the financial crisis intensifiedin mid-September 2007 and money growth has accelerated.

Monetary policy has, so far, played only a supporting role. The Fed has taken up

some of the slack created by the collapse of the securitization market. The Fedsactions have kept the credit crisis from taking a deeper toll on the economy.Eventually, confidence in the financial markets will be restored and the extraliquidity will help stoke a recovery, just as it has in every prior postwar recovery.

Fiscal policy played a supporting role in promoting economic recovery on a fewprevious occasions, most notably from recessions in the early 1960s and early 1980s.Fiscal policy will also play a major role in promoting a recovery from the currentdownturn. The $867 billion package signed into law last week will, at a minimum,support aggregate demand. Federal government action will also be needed toovercome the mountain of foreclosures and associated problems in the financialsector resulting from the housing boom.

A sustainable recovery will not take hold until confidence has been restored in thebanking system and broader financial markets. While the former has received agreat deal of attention, the latter is far more important than widely recognized.Banks only provide around 22 percent of the credit in our economy. The remainderis provided by the securitization market, foreign lenders, nonbank financialinstitutions and other lenders outside the financial services sector. A true fix for thefinancial system requires restoring confidence in all these credit providers, as well asthe related infrastructure of rating agencies and regulatory bodies.

Figure 13

Credit OutstandingPercent of Total Credit

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

83 85 87 89 91 93 95 97 99 01 03 05 07

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%Depository Institutions: Q3 @ 21.9% Securitized Assets: Q3 @ 14.3%

Other Financial: Q3 @ 36.7% Domestic Nonfinancial: Q3 @ 11.9%

Rest of World: Q3 @ 15.2%

``

Source: Federal Reserve Board and Wachovia

Banks only providearound 22 percent of thecredit in our economy.


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Summary and ConclusionsUnderstanding the current economic environment requires a look back at recent U.S.economic history. Some of the problems we face today were created over the pastfew years, while others have been gestating for decades. Economic policy over the

past quarter century or so has been more geared toward solving those short-termcyclical imbalances. Unfortunately, these actions have merely resulted in rollingmany of those longer-run imbalances into the next business cycle. Each successiveexpansion since the mid-1970s has resulted in higher levels of leverage throughoutour economy, particularly at the household level. The most recent expansion andsubsequent downturn suggest we have reached the limits of how far increasedleverage can paper over our long-run structural imbalances.

While we must correct the cyclical imbalances first, prosperity will not return to ournation on a sustainable basis until we address our long-term imbalances. The largestlong-run imbalance is the great productivity slowdown that began with the early1970s oil shock. The oil shock and productivity slowdown added to the inflationproblems of the late 1970s and early 1980s and sluggish real income growth that

accompanied it. Sluggish income growth led to a drop in the saving rate and theleveraging up of household balance sheets. We did enjoy a brief respite inproductivity growth during the later part of the 1990s, but it is far from certainwhether those gains are sustainable, and those gains did not flow through to workersand living standards.7

Policymakers understandably need to put the fire out before they can find out whatcaused it in the first place. The only real long-term way to promote improved livingstandards is to foster an environment where productivity growth re-accelerates on asustainable basis and this will not be easy. We need a Sputnik moment toreinvigorate the drive to boost productivity throughout our economy. Fiscal policycan play a role, by encouraging investment in more efficient plant and equipmentand improving secondary and post secondary education. There is no quick fix,

however, which means that once the economy does recover the pace of economicgrowth will have trouble sustaining the pace of growth seen in the 1980s and 1990s.With the benefit of hindsight, we now know that growth during those periods wasdriven by the unsustainable use of borrowing.

7 Gordan, Robert J. The Slowest Potential Output Growth in U.S. History: Measurement and Interpretation.Nov. 14, 2008.

The most recentexpansion andsubsequent downturn

suggests we havereached the limits ofhow far increasedleverage can paper overour long-run structuralimbalances.

We need a Sputnikmoment toreinvigorate the driveto boost productivitythroughout oureconomy.


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Wachovia Economics Group

ohn E. Silvia, Ph.D. Chief Economist (704) 374-7034 [email protected]

Mark Vitner Senior Economist (704) 383-5635 [email protected]

Jay H. Bryson, Ph.D. Global Economist (704) 383-3518 [email protected]

Sam Bullard Economist (704) 383-7372 [email protected]

Anika Khan Economist (704) 715-0575 [email protected]

Azhar Iqbal Econometrician (704) 383-6805 [email protected]

Adam G. York Economic Analyst (704) 715-9660 [email protected]

Tim Quinlan Economic Analyst (704) 374-4407 [email protected]

Kim Whelan Economic Analyst (704) 715-8457 [email protected]

Yasmine Kamaruddin Economic Analyst (704) 374-2992 [email protected]

Wachovia Corporation Economics Group publications are distributed by Wachovia Corporationdirectly and through subsidiaries including, but not limited to, Wachovia Capital Markets, LLC,Wachovia Securities, LLC and Wachovia Securities International Limited.

The information and opinions herein are for general information use only. Wachovia does notguarantee their accuracy or completeness, nor does Wachovia assume any liability for any loss thatmay result from the reliance by any person upon any such information or opinions. Such informationand opinions are subject to change without notice, are for general information only and are notintended as an offer or solicitation with respect to the purchase or sales of any security or as

personalized investment advice. 2009 Wachovia Corp.

This is Not the End of America_February 2009

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