Looking Forward: The Year Ahead

Speaker:Mark Zandi

MR. ZANDI: My task is to give you a sense of where the economy is headed, and I’m optimistic. Let me say it this way: I think 2012 will be a better year than 2011, and 2013 will be better than 2012. And I think actually the economy will perform very well in 2014 and ’15.

Just to give you a number to make that more concrete, GDP — the value of all the things that we produce — probably grew about 2 percent in 2011. We don’t have all the data yet, but it’s going to come in around 2 percent. I expect GDP to grow 2-1/2 to 3 percent this year, 3 to 3-1/2 percent in ’13, and closer to 4 percent in ’14 and ’15. That means more jobs. We created 1.6 million jobs in 2011, December to December. I expect a couple of million new jobs this year, two and a half million next, three million in ’14 or in ’15.

But even with that, what you might call the optimistic scenario, we don’t get back to full employment, which is a 5-1/2 to 6 percent unemployment rate, until 2015, 2016, or thereabouts. That gives you a sense of the hole we dug ourselves in and how much work we have to do to get out of it.

Before I go on, I should say I am not as optimistic about the finances of the higher educational system. That’s going to take longer to recover for a range of reasons, which we can discuss.

One other quick point before I move on. I am a bit outside the consensus. I think if you talk to the average macro economist, they’d be more pessimistic than I am. There’s a kind of prevailing pessimism, particularly in the academic world. Everyone’s been reading this book This Time is Different, the Rogoff/Reinhart book. And I think that’s coloring people’s thinking, but I think it’s wrong, or at least overstated. It is a very good book. I had only read bits and pieces of it until this Christmas holiday, when I read it cover to cover because it’s sort of gripping people’s thinking, so I thought I’d better read it very carefully. The book recounts previous financial crises in different countries throughout history, and what they meant for those economies and, more importantly, what it means for recoveries in the current context, and how economies perform in the wake of financial crises. It’s not pretty, it’s a long process.

My near-term optimism is rooted in the data. It’s pretty good. Holiday sales were solid – 4 or 5 percent year-over-year. That’s not boom times, but that’s not bad; that’s pretty good. Vehicle sales are picking up; they’re still low by historical standards, but showing steady improvement. (See Figure 1.)

Figure 1. Spent-Up Demand Gives Way to Pent-Up Demand
Sources: BEA, Moody’s Analytics

The job market has a much better tone to it too. Layoffs are as low as they generally get even in the best of economic times. The problem has been hiring, and even hiring is starting to pick up. So, we’re starting to get 150,000, 200,000 jobs created a month, and if we’re able to sustain that, that’s enough to start bringing down unemployment. The unemployment rate has already come down quite a bit; we’re at 8-1/2 percent. It’s declined more than half a point over the past several months, and I suspect it’ll fall more through the coming year.

Even the housing market, which has been the key albatross on the economy, has a much better feel to it. Home sales are better; they’re picking up, both new and existing. Construction is picking up, particularly for multi-family homes. House prices are soft, but they’ve essentially gone nowhere for the last two to three years. The data feel pretty good coming into 2012.

Potential Impediments to Growth

We have to overcome a few impediments to growth to stick to my optimistic script, and so let’s go through a few of those and consider the risks that they pose.

The first is Europe. Europe is a threat. The European economy is in recession. It’s contracting. My working assumption is that it will be a modest downturn, lasting through the mid-part of this year. The decline in GDP will be a point, point and a half, somewhere in that range. I don’t expect Europe to gain traction any time soon. It’s going to be a slog for the next three to five years, and Europe has a lot of hard work to do. But I think they’ll be able to avoid a severe unraveling of the Eurozone into a dark recession.

There are a lot of positive developments on that front, particularly the fact that the European Central Bank, the ECB, has stepped up and is being aggressive, lowering interest rates and lowering reserve requirements. It’s teamed up with the Fed, the Bank of England, and the Bank of Japan to provide cheap dollar funding to the banking system. And most importantly, the ECB is providing very cheap three-year money to European banks, and the banks can use pretty much anything they want as collateral to get that money.

The message is that there will not be a major bank failure in Europe, or at least not a disorderly bank failure. There will be orderly resolutions of problem institutions. Dexia would be a good example, the Belgian-French bank that failed — but no Lehman event. That has taken a lot of pressure off the financial system, and it’s the key reason why markets have rallied — even European markets have rallied pretty strongly.

Of course what the ECB is doing doesn’t solve anything fundamentally, but I think European policy makers are making progress addressing their fiscal problems as well. They’ve changed governments in Italy, in Spain, in Greece, all for the good. The current policy makers are making real headway in terms of addressing their fiscal problems. And the European Union is now erecting an edifice for a better fiscal union, and it’s already working. For example, the Belgians came up with a budget, and submitted it to the European Union. The EU said it’s not good enough, kicked it back to them, and they’re reworking it. So, it feels like the process is starting to work a little bit better.

Again, it’s going to be a slog, and there are going to be rounds of angst in the financial systems that won’t be all that graceful. To some degree, we almost need the pangs of angst in the financial system to generate the political will necessary for the Europeans to make these hard choices. I don’t think European policymakers can connect the dots for the electorate unless they can point to the turmoil in the financial market.

But I think we’re well past the worst of it in Europe. I think that we’re well on our way to resolving this in a reasonably graceful way.

The second potential impediment to my optimistic script in 2012 is the foreclosure crisis. That’s not over; it’s ongoing. Just to give you a number, there are 3.5 million first mortgage loans in foreclosure or pretty close to it. They are at least 120 days delinquent. If you add in the 90-day delinquent mortgages, which is not unreasonable, then we’re up to 4 million in loans in that predicament. There are just over 50 million first mortgage loans outstanding, so that’s a significant portion.

And it’s very possible that we’re going to see more house price declines as those properties in foreclosure move through the process to a distressed sale. That process has slowed down to some degree over the past year because of legal issues, the most notable being a lawsuit that state attorneys general have filed against the mortgage servicers over the robo signing scandal and other foreclosure process issues. That has slowed down the foreclosure process, so fewer properties have moved through the foreclosure pipeline to a distressed sale.

It looks like we’re going to get a legal settlement soon, and when that happens, the process will start to gear up again and we’ll probably get more price declines. (See Figures 2 and 3.)

Figure 2. A Mountain of Distressed Property…
Sources: Equifax, Moody’s Analytics

Figure 3. …Means More Distress Sales and Price Declines
Sources: FDIC, Equifax, RealtyTrac, Moody’s Analytics

My working assumption is that house prices nationwide will fall another 3 to 5 percent in 2012. If that’s the extent of it, then I think we’ll be fine. I think there are reasons to be optimistic that that will, in fact, be the extent of it. Investor demand for distressed property is very strong. Prices have now come down so far that investors can come in, buy the property, rent it, cover their costs, and hold on for a capital gain. And these folks aren’t flippers like the guys that were infecting the market back in the bubble. These are longer-term investors, for three, five, seven years. A lot of them are mom and pop investors.

I own a home in Vero Beach, Florida on this nice island, and there are 15 homes on my street. The property next to me went up for sale, a distressed sale, foreclosure sale. The price was unbelievable, and I was thinking, oh, I should buy this home, I should buy this home. I didn’t pull the trigger because I was already up to my eyeballs in real estate. I’m the economist working through the fourth order effects, and before I could pull the trigger, the neighbor on the other side bought the house.

So, to my point, there’s real value out there, and people in these neighborhoods see it, and they’re coming in and buying the property. So, I think the price declines will be quite modest in 2012.

One other reason for a bit of optimism here is that early stage first mortgage loan delinquency is actually quite low. If you look at the number of first mortgage loans that are 30-day delinquent, it’s all the way back to where we were before the recession began, even in the bubble time. And 60-day delinquent, that’s two months late, is pretty much back to its pre-recession level. Once we work through this admittedly large pipeline, on the other side of that we’re going to be in pretty good shape. And that explains some of my optimism regarding 2014, ’15, when I think house prices will be rising.

That’s very important to the higher educational system given that homeowners’ equity has been so key to financing a lot of education.

The third impediment that we need to overcome in 2012 to stick to my optimistic script is that we need to make some decisions with regard to fiscal policy in a more graceful way than we did last year. Last year was pretty disturbing. The S&P downgrade, as you know, didn’t mean a whole lot in terms of dollars and cents, but it was pretty debilitating psychologically. I think it caused people to pause, and certainly caused business people to pull back on their hiring.

And we came close to going back into recession last fall. There were other things going on, but the acrimony in Washington was debilitating. We need to make a few tough decisions this year — not a whole lot, but a few — without as much acrimony. The most important decision most immediately is what to do about the payroll tax holiday and the emergency unemployment insurance program. As you know, that was extended for just a couple of months through the end of February.

My working assumption — and this is important — is that these programs get extended through the end of the year. This means a lot of money for the economy, together about $150 billion. That’s about 1 percent of GDP. And if it’s not extended, that would be a problem. Growth would slow measurably in the spring and summer, and we’d probably be able to navigate through, but it would be nip and tuck. But I think the politics of this are such that they’re going to figure it out, and they’re going to extend those programs. But that’s an assumption.

The other key decision this year is what to do about the Bush-era tax cuts. As you know, they expire at the end of the year, and everyone’s tax rates are going up January 1st, 2013. I don’t think anybody wants that, and I don’t think we need that to establish what you might call fiscal sustainability. I think we’ve made a lot of progress addressing our fiscal issues, at least for over the next decade.

We do need some more tax revenue, and I think the expiration of the Bush-era tax cuts will be a key inflection point with regard to how much revenue we generate from increased taxes. But obviously it’s not clear how this all plays out. I don’t have a clear narrative in my mind as to how this will work out post-election. So that’s another potential flash point that I’m assuming we work through reasonably gracefully. But obviously that’s an assumption.

There are other things to worry about. I’m not going to go into them because I don’t want to depress you. I want to be upbeat and optimistic. There’s the potential for higher energy prices. That was a problem last year when gasoline got to $4 a gallon. I don’t think we’ll get there, but clearly that’s a risk.

And what’s going on in the emerging world is an issue. China, India, Russia, Brazil, Turkey, other countries, are trying to slow growth in a way that ends in a soft landing, so to speak. I think they’ll be able to get it done, but I’m assuming that, and obviously that’s another potential concern.

But even with all of these worries about the economy in 2012, I have to tell you that I’m much less nervous about it than I was three months ago. I think we’ve made significant progress in addressing these issues. There are still threats on the horizon, but they are much less threatening now.

Longer-Term Outlook

Let me now turn to trying to provide a little bit of confidence with regard to the longer-term outlook as we move into 2013 and ’14 and ’15, and give you some more fundamental reasons for optimism.

I’d say the most fundamental reason for optimism, and this goes to the argument in This Time is Different, is that we have come a long way to righting the wrongs that got us into this mess in the first place. The core reason for the financial panic and the great recession — I should say the “financial shock” because that’s the name of the book I wrote about it.

In any case, at its core, the reason for the financial panic and great recession was that the financial system made millions of bad loans, bad in the sense that even under reasonable economic assumptions they would not get repaid, and they didn’t. And it took the financial system to its knees and required a government bailout. We’ve been struggling with the fallout from that ever since.

But we’ve done a lot of hard work addressing that debt problem. Look at American businesses. We need to make a distinction between small companies and the big ones. The big companies are doing very well and the small ones not quite as well. But I would argue that U.S. companies, at least in aggregate, are in as good a financial shape as they have ever been. They’ve done a marvelous job reducing their costs. Productivity surged during the recessions. If there’s any good that comes out of losing 8.75 million jobs, and that’s what we lost due to the recession, it’s an increase in productivity, which goes right to the bottom line. So, profitability surged, and it’s extraordinarily high.

Balance sheets are strong. Just a couple of statistics: The interest coverage ratio — the share of cash flow that businesses are devoting to servicing their debt — has never been lower. And the quick ratio — the ratio of short-term assets, mostly cash, to short-term debt that comes due within a year — is at a record high. (See Figures 4 and 5.)

Figure 4. U.S. Businesses are in Great Financial Shape…
Source: BEA

Figure 5. …With Solid Business Balance Sheets
Sources: Federal Reserve, Moody’s Analytics

So, in my mind it’s no longer a question of whether businesses can hire and invest more. It’s really a question of willingness, so it’s a matter of confidence. And I think with the passage of time, as we get further away from the nightmare of the recession and we get some clarity with respect to policy, the regulatory environment, and the legal environment, I think businesses are going to engage and we’re going to see a lot more hiring. I think we’re pretty close to that point.

It takes one CEO in each industry to decide, “I can’t grow my earnings and defend my stock price by cutting costs. I have to grow my business and take a chance.” Then once that CEO goes, every CEO in that industry goes because they can’t lose market share. I think we’re really close to that light switch going on.

I have to say, though, that I thought we were pretty close this time last year, so you have to take this with a bit of salt. The collective psyche is very fragile. It doesn’t take a lot to derail it, so we need a little bit of luck. But assuming we get it, I think that light switch is going to flip, and we’re going to see much better job creation.

The financial system has done a marvelous job getting its leverage down. Again, we have to make a distinction between the small banks and the big banks. The big banks are, I would argue, as well capitalized as they’ve ever been. The stress testing process that they’ve been put through over the last couple of years has been very rigorous. They’ve had to raise capital sufficient to withstand losses consistent with those that we experienced in the two worst years in the 1930s, 1933 and 1934. In those two years the banking system had a cumulative loss rate of about 10 percent. They lost 10 percent of their assets through charge off. And our banks — our big banks, the too-big-to-fail banks, had to raise capital sufficient to withstand such losses.

Of course, we haven’t even come close to that. 2009 and ’10 were the two worst years because 2011 loss rates have come down quite a bit. In 2009 and ’10, the cumulative loss rate in the banking system was 3 percent — one-third of what it was back in the 1930s.

The banks are now capitalized to 10 percent, so they have a boatload of capital. They’re more profitable. Credit quality is improving dramatically. As I mentioned earlier, we’re going to see a lot of first mortgage delinquencies, but if you go look at delinquency rates on credit cards, on auto loans, on everything but student loans — by the way, that’s a mess — those losses have come in. Losses on commercial industrial loans have fallen quite dramatically. The banking system has benefitted enormously from that.

The only missing ingredient for the banks is more loan growth, and now they’re focused on making more loans. The credit spigot is opening. Bank lending to businesses is now up double digits year-over-year. It feels like the banks are engaging again. (See Figures 6 and 7.)

Figure 6. Banks Are Well Capitalized and More Profitable…
Source: FDIC

Figure 7. …and Thus Opening the Credit Spigot…
Source: Federal Reserve Senior Loan Officer Survey

The banks have a lot of legal and regulatory issues to iron out. They’re working through Dodd-Frank and Basel III and other things, so it’s going to take a little bit of time, but I think we’re going to see a lot more credit flowing. And they’ve righted a lot of the wrongs.

I mentioned households earlier. I think the last problem in the household sector is first mortgage delinquencies. Student loans are also an issue. But outside of that, household balance sheets are strong. (See Figures 8 and 9.)

Figure 8. Households Rapidly Deleverage…
Sources: Federal Reserve, BEA, Moody’s Analytics

Figure 9. …Which is Evident In Improving Credit Quality
Sources: Equifax, Moody’s Analytics

Finally, I’ll end with our collective balance sheet, our fiscal situation. I think we’ve made a lot of progress establishing what you might call fiscal sustainability, and that some good came out of the mess surrounding the debt ceiling debate. Democrats and Republicans agreed to a little over $2 trillion in spending cuts over the next 10 years.

I think it’s going to be pretty hard to back away from those cuts. It would require passing a piece of legislation saying, no, we’re not going to do that. And in this political environment, I don’t think that’s going to happen, at least not for a long time.

To achieve fiscal sustainability, meaning a deficit that’s low enough to stabilize the nation’s debt to GDP ratio, which should be our goal, we need about $4 trillion in deficit reduction over the next 10 years. So, we’ve got a little over half of that.

And as I mentioned earlier, the Bush-era tax cuts are coming to expiration. If we allow the tax rate on the top bracket to revert back to its pre-Bush levels –- that is, the top tax rate we had in the 1990s — from 35 percent back up to 39.6 percent, that will generate about a trillion in revenue over 10 years. If we let the top two brackets go up, then we’ve got more than enough. We achieve fiscal sustainability.

Frankly that’s where I think we’re headed. Come this time next year, I think people are going to feel a lot more optimistic about our fiscal issues.

None of this solves our longer-term problems, though. I’m really focused on the next 10 years, not on the cost of Medicare and higher education. There is dark pessimism, and I don’t want to dismiss it because, as I said earlier, the collective psyche is fragile and it wouldn’t take much to upend it, in which case we’d be right back into the soup. But at this point, the fundamentals are much better.

I’m not arguing this time is different. All I’m arguing is that the United States of America is different. That sounds like I’m running for office, but I’m not. We have a very flexible economy, and we adjust incredibly rapidly to challenges. That’s our strength, and that’s evident in today’s economy. I just don’t think it has seeped into the collective wisdom, at least not so far.

Looking at the return to education, I’m on board with sending my kid to college. But I’m also a big stock investor at this point. I think we can get some good returns there.

With that, I’ll stop and turn it back to you.


SPEAKER: Can you give us your comments about student loan debt? In a recent report, it is estimated to exceed credit card debt in our country.

MR. ZANDI: Yes, it already has. We collect the data based on credit files from the bureau Equifax. And according to our data, as of December 2011, there was $770 billion in student loan debt outstanding. I’ve heard in various press accounts estimates up to a trillion dollars. I’m not sure where that’s coming from. It’s not in my data, so I’m a little confused by that. Regardless, that’s a boatload of debt. For context, there’s $625 billion outstanding in credit card debt. That’s falling, and has been falling for three years now. Meanwhile, student loan debt has been growing at a double digit pace pretty consistently.

About $670 billion of the student debt is government debt. It’s backed by the federal government — these are federal loan programs. One hundred billion of the $770 billion is private student loan debt, not backed by the government. The private market feels reasonable to me, looking at the data. I’ve looked pretty closely at Sallie Mae’s financials, and they seem to have tightened up on underwriting. They’re making credit-based decisions, and quality is okay. They seem to be doing a pretty good job, and the other private lenders seem to be following suit. So, I’m not particularly worried about that part of the market.

But the government lending is a mess. It’s not credit-based — that is, it’s not based on the credit worthiness of the borrower, it’s based on need. That’s just a problem waiting to happen. Loss rates are already rising very rapidly, and they are going to continue to rise rapidly because in many cases a lot of bad lending has been and still is being committed. A banker once told me if it’s growing like a weed, it probably is a weed. I think that definitely applies here.

It takes time to figure that out because loans don’t go delinquent rapidly, and they get forbearance, and so forth and so on. But I think if you look a few years down the road, it’s going to be a major problem to the degree that it’s going to be a political issue, and the whole system is going to be changed because loss rates are going to be way too high.

So, I think the availability of student loan credit will be significantly impaired at some point in the future.

SPEAKER: And if you default on your student loan, you’re pretty well wrecked for a long, long time.

MR. ZANDI: For a long time.

SPEAKER: However, we are moving toward more of an income-contingent basis for loan repayments, which may mean the government will end up eating some of that.

MR. ZANDI: That’s my point. It is going to cost taxpayers a bundle, and people are going to get angry. This isn’t a subprime crisis, it’s on the government’s tab, not on the private financial system’s tab. We are not going to see the too-big-to-fail institutions fail and cause systemic risk, but this is going to cost a lot of money.

The financial crisis, excluding all the stimulus, will probably end up costing a couple hundred billion dollars, even if you throw Fannie Mae and Freddie Mac into the mix. That’s the total cost, again, excluding the fiscal stimulus. That includes the bank bailout, auto bailout, housing bailout, Fannie and Freddie — altogether a couple hundred billion.

I expect that loss rates on the student loan portfolio over the next 10 years will be on par with that. That’s the magnitude of the problem. And I don’t think people are going to sit by and allow that. I think that’s going to ignite major changes in the way we do lending. The bottom line will be there’ll be a lot less student loans available, not next year, not the year after, but four, seven, 10 years down the road.

SPEAKER: To add to that last point, the Obama Administration has significantly changed and lowered the credit standard of something called parental loans for undergraduate studies. So, the credit standards that used to be at least reasonable have been very much weakened in the last three years, and the amount of money being borrowed has risen even higher.

The credit quality that we’re turning out right now is substantially worse than what’s been turned out for the last 30 or 40 years.

MR. ZANDI: Yes, that’s correct. I would agree with that assessment.

SPEAKER: I appreciate your optimism, and I think you make a pretty strong case based on the economic factors. The dilemma I see is the political factors. I think there are people in the political process now who would actually prefer a double-dip recession so that they would have more of a likelihood of being in control.

That’s part of what led to the instability in the financial system this past year, which in some respects had less to do with the financial or economic indicators and more to do with the spirit of the country and the culture around this.

How do you make the economic factors drive the economics rather than the political factors?

MR. ZANDI: That’s a good question. I forecast what policymakers do. It used to be I forecasted the economy; now I forecast what they do because that affects the economy. It has made forecasting all the more intrepid and difficult.

Having said that, though, I think policy makers and their decision-making are going to play much less of a role in 2012 and going forward.

In 2012, I think the political process has essentially been neutered. I mentioned one key decision about the payroll tax and the unemployment insurance programs, but the politics of those are such that I’d be very surprised if there were any hang up there. I think they’ll get extended.

Then I think we go into hibernation politically, and then on the other side of the election we have to address the Bush-era tax cuts.

There’s one other possible place where things could go astray. The federal government’s fiscal year ends in September, and Congress has only funded the government through the end of September. So, come early October, you could construct a scenario where someone’s angry about the defense cuts that are coming under sequestration and says, “I’m willing to shut the government down to change that.” This is now a month before the election. Of course, if there was a government shutdown at that point, that doesn’t fit my script. That would be a problem.

But at this point I think that has a low probability of happening. The politics of that, too, are such that people don’t want to be blamed for that right before the election.

So, election year politics makes it such that policymakers are going to play less of a role in determining our fate, at least in 2012. And hopefully by 2013, the underlying positive dynamics in the private sector will have taken hold to the degree that the politics matter less on the other side of the election. And hopefully the election itself is a somewhat therapeutic process. Presumably someone’s going to get some kind of mandate and everyone reasonably agrees that whoever wins should decide some of these things.

Great. Anything else bothering anybody?

SPEAKER: No, it’s all hunky dory.

MR. ZANDI: Well, thank you. I appreciate the opportunity.