U.S. Review

Modest Economic Growth Continues

• Third-quarter GDP rose 2.5 percent, supported primarily by gains in consumer spending and business investment. State and local spending cuts continued to detract from economic growth.
• Personal incomes grew a slight 0.1 percent in September, with real disposable income declining by 0.1 percent. Even with the slow pace of income growth, consumers increased their spending for the month by 0.6 percent.
• Housing data this week continued to reflect the slow pace of recovery for the housing industry. The pace of recovery will continue to vary considerably by region.
  

Broad-Based Economic Growth for Q3
The dominant story of the week was the release of the first look at third-quarter GDP, which indicated that the economy expanded at a moderate pace for the quarter. Other key releases this week included a look at the consumer sector, with the release of consumer confidence and September personal consumption. Housing market data this week again reflected the very depressed state of the housing market. Durable goods orders fell in the month of September due to a pullback in aircraft orders, as several of the manufacturing sentiment indices remained in contractionary territory.

The pace of economic growth increased 2.5 percent in the third quarter of this year, supported by stronger consumer and business spending. Strong improvement in the consumption of health-care services bolstered consumer spending. Business investment rose 13.7 percent, as firms continued to invest in equipment and new facilities. State and local government expenditures remained a drag on growth, as spending among these governments has pulled back dramatically and now more closely match the slower pace of revenue growth. Given the broad-based gains within GDP in the third quarter, we have upwardly revised our outlook. We now expect GDP to grow 1.8 percent for the year, and the stronger end to 2011 means real GDP will likely grow 2.1 percent in 2012.

Consumer confidence in September fell back to its lowest level in two years. Consumer sentiment remains very depressed and future expectations continue to fall. One noticeable trend that has emerged over the past couple of months is the separation between consumer confidence and actual consumer behavior. Strong retail sales in September combined with a 0.6 percent jump in personal spending suggested that, while consumers are not confident, they are at least still buying. Personal income remains the largest headwind to consumer spending growth. A 0.1 percent decline in real disposable income in September reiterated that the slow pace of personal income growth is not outpacing the rise in inflation.

Durable goods orders for September fell slightly, as civilian aircraft orders slipped 26 percent on the month. The most encouraging news from the report was the surge in capital goods orders excluding aircraft, which rose 2.4 percent, suggesting that business investment remains strong. We continue to expect capital investment on the part of businesses to remain a key growth driver over the next year.

Housing data this week continued to signal a slow pace of recovery in the new home market. September new home sales rose 5.7 percent after declining for four consecutive months. New home prices continued to fall for the month, but the gap between new and existing homes remained wide, providing little incentive for homebuilders to ramp up construction activity. Pending home sales also sank 4.6 percent in September, with declines in every region of the nation. The housing market in general will continue to slowly improve, but the pace of growth will vary considerably by region.

Global Review

Is the European Debt Crisis “Solved” Now?

• European leaders agreed to a number of steps this week in another attempt to solve the debt crisis that has been plaguing the Eurozone for nearly two years. The steps likely will put the crisis on the back burner again, at least for the time being.
• However, the crisis will not truly be solved until some of the indebted countries, especially Italy, adopt policies to boost their long-run rates of economic growth. Without strong growth, highly indebted countries would need to run politically unsustainable budget surpluses to stabilize their debt-to-GDP ratios.
  

Leaders of the European Union (EU) gathered this week in another attempt to “solve” the sovereign debt crisis that has plagued the Eurozone for nearly two years. Leaders finally acknowledged that the continent’s banking system is woefully undercapitalized and agreed to a recapitalization scheme worth about €100 billion. Systemically important banks will have until June 2012 to raise capital. If they are unable to do so on their own, authorities will inject public monies into the banks.

The EU leaders and representatives of the private sector agreed to a “voluntary” 50 percent haircut on the outstanding amount of Greek government debt. However, crucial details about exactly how the restructuring is to take place have not yet been released. The leaders also announced that the €440 billion rescue facility, the so-called European Financial Stability Facility (EFSF), would be leveraged, bringing the size of the fund to more than €1 trillion. Crucial details, however, were left for another day.

It’s All About Growth, Stupid

Recapitalizing the banking system, reducing the outstanding amount of Greek government debt and increasing the size of the EFSF and are necessary conditions to solving the crisis. However, they are not sufficient conditions. In our view, the crisis will not truly be solved until some of the indebted countries, especially Italy, adopt policies to boost their long-run rates of economic growth. As we wrote in a special report this summer, debt sustainability depends, at least in part, on nominal GDP growth. (See “With Greece ‘Stabilized’ Will the Fire Spread?”, which is available upon request.) If nominal GDP growth is strong, a country can grow its way out of its fiscal problems. On the other hand, weak growth means that a country needs to undertake painful austerity measures to stabilize its debt because a country cannot increase its debt-to-GDP ratio indefinitely. Sooner or later, lenders will balk at extending the country more credit.

In that regard, nominal GDP growth in Italy has averaged only 3 percent per annum in the past decade, and the IMF projects that, under current policies, growth will remain anemic over the next few years. If, for example, nominal GDP growth in Italy grows only 2 percent per annum and borrowing costs remain near current rates, the Italian government would need to incur a primary surplus (budget surplus less debt interest payments) of roughly 5 percent of GDP to stabilize its debt-to-GDP ratio, which currently exceeds 120 percent. Although not impossible, a primary surplus of this magnitude for a number of years would be politically very difficult to achieve.

What is needed are structural reforms to lift Italy’s long-run growth rate. The Italian government has promised to raise the retirement age and to implement reforms to the country’s ossified labor market. These promises now need to be implemented. In our view, EU leaders have probably done enough to put the crisis on the back burner for now. However, if indebted countries do not implement policies to enable them to grow, the crisis likely will rear its ugly head again.

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