The Optimism of Last Year's Final Days Has Faded

The downhill trend in the US economy could become a way of life.

The U.S. economy has slowed down dramatically recently, and the probability of another economic downturn increases with each new round of data. This is a sharp change from the economic situation at the end of last year - and represents a return to the very weak pace of expansion since the recovery from the GFC began in the summer of 2009.

Economic growth in the US during the first three quarters of last year was not only slow but was dominated by inventory accumulation rather than sales to consumers or other forms of final sales.

The last quarter of last year brought a welcome change, with consumer spending rising at a rate of 4 per cent a year, enough to increase total real gross domestic product (GDP) by 3.1 per cent from the third quarter to the fourth. The economy seemed to have escaped its dependence on inventory accumulation.

Advertisement: Story continues below

This favourable performance led private forecasters and government officials to predict continued strong growth for this year, with higher production, employment, and incomes leading to more consumer spending and a self-sustaining recovery. A one-year cut of the payroll tax rate by 2 percentage points was enacted to lock in this favourable outlook.

Unfortunately, the projected recovery in consumer spending did not come. The rise in food and energy prices outpaced the gain in nominal wages, causing real average weekly earnings to decline in January, while the continued fall in home prices reduced wealth for most households. As a result, real personal consumer expenditure rose at an annual rate of just 1 per cent in January, down from the previous quarter's 4 per cent increase.

That pattern of rising prices and declining real earnings was repeated in February and March, with a sharp rise in the consumer price index causing real average weekly earnings to fall at a rate of more than 5 per cent a year. Not surprisingly, survey measures of consumer sentiment fell sharply and consumer spending remained almost flat from month to month.

The fall in house prices pushed down sales of both new and existing homes. That, in turn, caused a dramatic decline in the volume of housing starts and housing construction. That decline is likely to continue, because nearly 30 per cent of homes with mortgages are worth less than the value of the mortgage. This creates a strong incentive to default, because mortgages in the US are effectively non-recourse loans: the creditor may take the property if the borrower doesn't pay, but cannot take other assets or a portion of wage income. As a result, 10 per cent of mortgages are now in default or foreclosure, creating an overhang of properties that will have to be sold at declining prices.

Businesses have responded negatively to the weakness of household demand, with indices maintained by the Institute of Supply Management falling for both manufacturing and service companies. Although large companies continue to have substantial cash on their balance sheets, their cash flow from current operations fell in the first quarter. The most recent measure of orders for

non-defence capital goods signalled a decline in business investment.

The pattern of weakness accelerated in April and May. The relatively rapid rise in payroll employment that occurred in the first four months of the year came to a halt in May, when only 54,000 new jobs were created, less than one-third of the average for employment growth in the first four months. As a result, the unemployment rate rose to 9.1 per cent of the labour force.

The bond market and share prices have responded predictably to all this bad news. The interest rate on 10-year government bonds fell to 3 per cent, and the sharemarket declined for six weeks in a row, the longest bearish stretch since 2002, with a cumulative fall in share prices of 6 per cent. Lower share prices will now have negative effects on consumer spending and business investment.

Monetary and fiscal policies cannot be expected to turn this situation around. The Federal Reserve will maintain its policy of keeping the overnight interest rate at near zero. But, given a fear of asset-price bubbles, it will not reverse its decision to end its policy of buying Treasury bonds - so-called ''quantitative easing'' - at the end of June.

Moreover, fiscal policy will actually be contractionary in the months ahead. The fiscal-stimulus program enacted in 2009 is coming to an end, with stimulus spending declining from $US400 billion ($A377 billion) in 2010 to only $US137 billion this year. And negotiations are under way to cut spending more and raise taxes in order to reduce further the fiscal deficits projected for 2011 and later years. So the near-term outlook for the US economy is weak at best. Fundamental policy changes will probably have to wait until after the presidential and congressional elections in November 2012.

Martin Feldstein was a professor of economics at Harvard.