MONEY The Economy

China is Slowing. What If Its Housing Bubble Bursts?

Even if the real estate market in the world's second-biggest economy were to collapse, the repercussions may not be bad as you think.

While global investors covet China’s growth — as evidenced by the buzz surrounding Alibaba’s IPO — the Chinese economy is actually slowing down.

In 2013, the world’s second largest economy grew at an annual rate of 7.7%. By 2015, according to a recent report by the Organization for Economic Co-Operation and Development, that will drop to 7.3%. Meanwhile, the U.S. economy’s growth rate is projected to increase by almost one percentage point.

What’s going on? Well, China’s industrial production gains in August slowed to their lowest level since 2008 and retail sales growth declined by a few percentage points year-over-year.

Perhaps most important, the nation’s newly built home prices only grew by 2.5% in July, after surging by 10% at the beginning of the year.

The notion of a housing crisis in an economy more than three times the size of France brings back flashbacks of 2008 and probably a few chills down every investor’s spine.

“A property price crash in the world’s second largest economy would have global implications,” says Wells Fargo Securities economist Jay Bryson.

But those global implications wouldn’t be as worrisome as the U.S. housing collapse six years ago, per Bryson. Here’s why.

The Worst Case

To play out this thought experiment you have to assume that at some point in the near future China’s home prices will experience a decline on the order of what the U.S. experienced over the past decade. (Bryson played out this scenario in a recent report.)

Currently, residential investment makes up a pretty decent portion of the Chinese economy – about 10% of nominal GDP. To put that in context, that ratio was closer to 6% for the U.S. in 2006.

So housing is a big deal in China. If they experienced a value decline like we did, Bryson estimates that would lop off about one percentage point of growth. But the pain wouldn’t stop there.

A collapse in housing prices would result in fewer construction jobs – estimated at around 60 million people in urban China. Jobless workers would spend less, which means that those goods and services the now-unemployed construction workers would normally purchase would not get bought.

If out-of-work construction workers reduce their spending on food and entertainment, the businesses that produce that food and entertainment will make less money and then some of their workers may face unemployment too. Since my spending is your income, lower spending means people have less money in their paychecks, and the nation’s GDP suffers.

Moreover, if housing goes in the tank, banks will see losses, which means they’ll tighten credit, resulting in fewer loans for people to start businesses.

Let’s not forget the actual homeowners. If home prices fall, homeowners’ equity declines as well. (See: Sell, Short). And when people’s chief asset is suddenly worth a lot less, they’re not going to spend as much on other, discretionary items. “Although the lack of data makes it impossible to quantify the wealth effect in China, researchers have found that there is a statistically significant direct relationship in the United States between changes in wealth and changes in consumer spending,” per Bryson’s report.

Lower demand from China means that countries which sell goods to China (think Chile and Australia) will sell less stuff. As corporate profits are squeezed, a global bear market may result.

“Although China may not be as important to global economic growth as the United States, the global economy clearly would not be immune to a major property market downturn in China,” says Bryson.

The Not-So-Bad Case

Freaked out? Breathe deep and take solace in the fact that despite this potentially harrowing dénouement, the world probably wouldn’t endure another global financial crisis. And that’s thanks to responsible Chinese borrowers.

Chinese households usually have to put a lot more money down – 30% on their first home, up to 60% for an individual’s second – than Americans. So if prices were to decline substantially, Chinese homeowners would be in a much better position than Americans back in 2007 to deal with the crisis. For example, household debt-to-disposable income has grown substantially in China since 2007, but it’s still about one-third the size of U.S. households back in 2007.

The world will also feel less of a pinch. When mortgages started going bad in the U.S., foreign financial institutions lost close to $750 billion of the more than $2 trillion in write-downs resulting from the crash. That was because foreign banks owned a lot of U.S. mortgage-backed securities. Not so here. “Chinese mortgages are generally held by Chinese financial institutions in the form of whole mortgages.” So if prices were to drop, Chinese banks would suffer while U.S. one’s most likely wouldn’t.

Lastly, the Chinese government wouldn’t sit on its hands while its economy came crashing down. Beijing’s debt-to-GDP ratio is around 15%, so it has a lot of room to recapitalize its banks if needed.

So what’s an investor to do?

“I don’t lose sleep at night worrying about China, nor should other people,” says Bryson. “But they may want to keep an eye on it.”

MONEY Jobs report

How the Fed Will React to Today’s Surprising Jobs News

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altrendo images—Getty Images

The fact that employers created fewer jobs than expected in August only emboldens the Federal Reserve to keep rates low for the time being.

The Fed is unlikely to raise interest rates this year — and not just because of Friday’s disappointing jobs report.

Though the economy fell short of adding 200,000 jobs in August — as it had in the six prior months — the unemployment rate remains at a better-than-expected 6.1%. Consumer confidence, meanwhile, rose in August and the economy grew by a robust 4.2% last quarter.

Many have long-waited for the time when the economy picks up and the Federal Reserve raises interest rates along with it. Even the presidents of the St. Louis and Philadelphia Federal Banks recently said the nation’s central bank should raise interest rates sooner than expected thanks to job gains and slightly rising inflation.

But given muted inflation and the growing concerns in Europe — where the economy threatens to slip back into recession and central bankers are still slashing rates in a desperate attempt to jumpstart business activity in the region — Fed chair Janet Yellen was unlikely to act soon. And today’s Labor Department report, showing that only a modest 142,000 jobs were created in August, only reinforces this.

Jobs

The unemployment rate has already dropped more than half a percentage point this year.

US Unemployment Rate Chart

US Unemployment Rate data by YCharts

But that’s just one way to look at the labor market. Another is the labor force participation rate. Since younger Americans tend to go school, and Baby Boomers are beginning to retire en masse, you can look at the participation rate for workers between the ages of 25 to 54. Before the recession almost 80% of those Americans were working or looking for a job. Now, 77% are. To put that into perspective, 81% of prime aged workers in France participate in the labor force.

Another, more inclusive, employment metric is the so-called U-6 rate of unemployment — which includes unemployed workers, Americans who want to work but have stopped looking for a job, and part-time workers who’d rather put in full-time hours. The U-6 rate has dropped from about 17% after the recession to 12% now, but that’s still close to four percentage points higher than before 2008.

u-6

Here’s Yellen from her Jackson Hole speech a couple of weeks ago:

At nearly 5% of the labor force, the number of such workers is notably larger, relative to the unemployment rate, than has been typical historically, providing another reason why the current level of the unemployment rate may understate the amount of remaining slack in the labor market.

Inflation

Despite predictions of increased inflation thanks to unorthodox monetary policy, deflation has been a bigger concern since the recession than inflation. Nevertheless, some central bank officials are still worried about an unexpected rise in prices thanks to an improving jobs situation and want to head off that potential rise with higher interest rates.

As Philadelphia Fed President Charles Plosser said on a Bloomberg Radio interview, “I would rather us get started raising rates sooner and raise them more gradually than put them off and have to raise them very quickly.”

The Congressional Budget Office disagrees. The non-partisan agency predicted that over the next 10 years inflation will only rise around 2% a year, in a recent report. “CBO anticipates that prices will rise at a modest pace over the next several years reflecting slack in the economy and widely held expectations for low and stable inflation.”

Right now core inflation, according to the Federal Reserve’s preferred measurement, grew by 1.5% in July over the previous 12 months. That’s well below the Fed’s target rate of 2%.

Europe

Depressed Americans need only look across the pond to see how badly our recovery could be going. The Euro zone area experienced no growth in the second three months of 2014. Combine that with ultra-low inflation and you have the recipe for economic stagnation. Even the vaunted German economy stalled.

This three-year experience of little economic traction follows the European Central Bank’s decision to raise interest rates in 2011 during the sovereign debt crisis in order to fight inflation. Quash it they did. Prices recently rose by an annual rate of only 0.3% in August in the 18-country Euro zone, prompting ECB President Mario Draghi (who wasn’t in charge back then) to drop interest rates to an all-time low of 0.05%.

Eventually American consumers will see raises and go off and spend that extra cash. Demand will not stay depressed forever, and the Fed will one day raise interest rates. That decision, though, is more likely to be later than sooner.

MONEY The Consumer Economy

The Real Reason You’re Not Shopping at Walmart

Female shopper in Wal-Mart store aisle
Patrick T. Fallon—Bloomberg via Getty Images

Despite the improving job market, workers still don’t have that much walking around cash, which means they have less to spend at retailers.

The summer has not been kind to some of America’s largest retailers.

Traffic at Wal-Mart’s U.S. locations, for instance, was down, while sales at stores that had been open for at least a year failed to grow. Macy’s lowered its full-year sales growth projection, and sales at Kohl’s dropped 1.3% in the last three months. Nordstrom’s earnings per share were basically flat.

If you’re noticing a trend, that’s because there is one: Merchants are struggling.

The Commerce Department recently announced that retail sales decelerated in July for the fourth consecutive month, despite the fact that more workers are finding jobs, and the unemployment rate is hovering around 6%. So what’s going on?

Well, one potential answer is that you, the consumer, just don’t have that money to spend. Yes, employers have added more than 200,000 workers a month to their payrolls since February. And yes, the unemployment rate has dropped to 6.2%—about the same as in September 2008. But workers really haven’t seen the benefits of job growth in their bottom lines.

For instance, take a look at real disposable income for U.S. workers. The year-over-year change in disposable income is only 3.9%, below pre-recession levels. “While stronger job growth has played a role in sustaining consumer spending, the slower income growth has served to keep a lid on real spending activity over the past several quarters,” per a recent Wells Fargo Securities economic report.

disposable income

 

Another way to gauge the plight of workers is a metric called the Employment Cost Index (ECI), which is published by the Bureau of Labor Statistics. The ECI measures what it costs businesses to actually employ their workers—so, wages, salaries and fringe benefits like medical care. Before the Great Recession struck in 2007, the ECI gained nearly 3.5% over the prior 12 months. Since the economic recovery, however, employee costs have not risen above 2%.

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Rising wages are a lagging indicator; people only see raises after the jobs picture improves. Which is happening now. Fewer people are filing unemployment claims, and the number of job openings continues to nudge higher. (And traditionally, job openings have an inverse relationship with wage gains.)

So, hopefully, sometime soon demand will pick up, businesses will start giving their workers substantial raises, and those workers will go out and spend their newfound dollars. (After all, my spending is your income.)

What’s good for the economy is sometimes what’s good for Wal-Mart.

MONEY Jobs

What’s the Deal with America’s Declining Workforce?

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Getty

The dwindling percentage of Americans who are employed or looking for work is partly due to the economy—but mostly not. Here's what that means for the recovery and you.

If you feel like the economy has finally started to gain steam, you’re not alone. U.S. gross domestic product (GDP) grew by 4% last quarter, and today the Labor Department announced that employers added 209,000 jobs in July, after posting 298,000 in June and 229,000 in May.

One theme, though, that has persisted throughout the slow recovery: The share of Americans working or looking for a job is dropping, despite the improving employment picture.

LFPR

While this trend has been used to illustrate how sluggish the rebound has been, it actually predates the Great Recession. Today 62.9% of Americans participate in the labor force, compared to 66.1% six years ago and more than 67% in 2000.

So, what exactly is going on?

The White House’s Council of Economic Advisers set out to answer that very question.

Last month, it issued a report dryly titled: “The Labor Force Participation Rate Since 2007: Causes and Policy Implications” in which economists cite three key developments:

#1) America is just getting older

About half of the decline in worker participation over the last seven years is due to demographics — the workforce is simply aging. About one-sixth of the population was at or above retirement age in 2009, according to the report. By 2029, that number will increase to 25%, per the Social Security Administration.

Older workers generally work less than their younger counterparts.

But, interestingly, this group is working more than it used to. From 2007 to 2014 the only age group that saw labor-force participation rates rise was the 55-and-older crowd.

Old lfp

Why? One reason is this generation of older workers is better educated than its predecessors. In fact, “between 1876 and 1950, the average years of schooling for each birth year cohort increased steadily every year,” per the CEA. More education means higher wages and less physically demanding jobs.

#2) Normal post-recession issues

When the economy is going well, labor participation rates tends to increase. Faster growth means businesses are more apt to hire, which means individuals without jobs feel more confident in their chances of finding work — and hence send out more applications.

When the economy shrinks, this virtuous cycle turns vicious.

“Economic contractions historically result in both greater unemployment and lower labor force participation, as nonparticipants become less likely to enter the labor force and the unemployed (who always exhibit a higher tendency to exit the labor force) become more numerous relative to the unemployed,” per the report.

The CEA estimates that about 16% of the drop in labor force participation rates can be attributed to the fact that fewer people work and look for jobs when the economy is shaky.

#3) Other Stuff

The last third of the decline is traced to two elements — one of which predates the recession, while the other may be a result of it.

The bit related to the Great Recession is long-term unemployment. Right now, more than 3 million workers have been without a job for 27 weeks or longer. While that’s down from almost 7 million in 2010, it’s still 2 million more than before the downturn.

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The other rationale is a combination of long-term trends affecting different groups of workers.

For instance, younger Americans (aged 16-24) — especially those from lower- and middle-income families — have eschewed entering the work force for going to college for years now. As the value of a college education for future earnings increases, more youngsters are hitting the books.

Also, older workers who’ve been hit by the dearth of middle-skilled jobs, according research from Fed economist Christopher Smith, are now taking jobs that would have normally gone to younger workers.

After growing dramatically for the better part of 50 years, the rate of female employment has leveled off and begun to fall since the end of the 20th century, down almost three percentage points.

What’s going on? Well more women are staying home to care for their children, according to the Pew Research Center. In 2012, the percentage of stay-at-home moms increased 6 percentage points to 29% from 13 years earlier.

This is a phenomenon that’s uniquely American.

Since 1991, the participation rate of prime age working females in the Netherlands, Germany, Canada and Japan has all made significant gains, while the U.S.’s has remained flat. “Research has found that family-friendly policies are partially responsible for the rise in participation in other advanced countries, and the lack of these policies explains why the United States has lost ground,” according to the CEA.

women labor force prime

While a higher percentage of women entered the workforce after World War II (until the 2000’s), pretty much the exact opposite is true of males. In 1948 almost 97% of men aged 25-54 worked or were looking for jobs. That number has been declining for over 60 years and is now closer to 88%.

male rate

The causes of this precipitous drop are not exactly clear, although some research shows that the decline is in part due to the fewer jobs based on brawn.

manu

The implications

This picture of the labor market complicates recent reports showing an accelerating economy and increased employment. It also helps explain why the Federal Reserve, led by chair Janet Yellen, isn’t that eager to quickly raise interest rates despite positive economic reports and slightly higher inflation.

And while a certain percentage of the decrease in labor force participation rate can be attributed to the recession, a lot of the decline is bigger than that.

The question now is will Americans return to the labor force in greater numbers without new policies by the Congress and the White House that address long-term headwinds facing American workers?

MONEY The Economy

Think the Fed Should Raise Rates Quickly? Ask Sweden How That Worked Out

Raising interest rates brought the Swedish economy toward deflation Ewa Ahlin—Corbis

Some investors are impatient for the Fed to raise interest rates. They may want to be a little more patient after hearing what happened to Sweden.

If you’re a saver, or if bonds make up a sizable portion of your portfolio, chances are you’re not the biggest fan of the Federal Reserve these days.

That’s because ever since the financial crisis, the nation’s central bank has kept short-term interest rates at practically zero, meaning your savings accounts and bonds are yielding next to nothing. The Fed has also added trillions of dollars to its balance sheet by buying up longer-term bonds and other assets in an effort to lower long-term interest rates.

Thanks to some positive economic news — like the recent jobs report — lots of people (investors, not workers) think the Fed has done enough to get the economy on its feet and worry inflation could spike if monetary policy stays “loose,” as Dallas Fed President Richard Fisher recently put it.

If you want to know why the argument Fisher and other inflation hawks are pushing hasn’t carried the day, you may want to look to Sweden.

Like most developed nations, Sweden fell into a recession in the global financial crisis. But unlike its counterparts, it rebounded rather quickly. Or at least, that’s how it looked.

As Neil Irwin wrote in the Washington Post back in 2011, “unlike other countries, (Sweden) is bouncing back. Its 5.5 percent growth rate last year trounces the 2.8 percent expansion in the United States and was stronger than any other developed nation in Europe.”

Even though the Swedish economy showed few signs of inflation and still suffered from relatively high unemployment, central bankers in Stockholm worried that low interest rates over time would lead to a real estate bubble. So board members of the Riksbank, Sweden’s central bank, decided to raise interest rates (from 0.25% to eventually 2%) believing that the threat posed by asset bubbles (housing) inflated by easy money outweighed the negative side effects caused by tightening the spigot in a depressed economy.

What happened? Well…

Per Nobel Prize-winning economist Paul Krugman in the New York Times:

“Swedish unemployment stopped falling soon after the rate hikes began. Deflation took a little longer, but it eventually arrived. The rock star of the recovery has turned itself into Japan.”

And deflation is a particularly nasty sort of business. When deflation hits, the real amount of money that you owe increases since the value of that debt is now larger than it was when you incurred it.

It also takes time to wring deflation out of the economy. Indeed, Swedish prices have floated around 0% for a while now, despite the Riksbank’s inflation goal of 2%. Plus, as former Riksbank board member Lars E. O. Svensson notes, “Lower inflation than anticipated in wage negotiations leads to higher real wages than anticipated. This in turns leads to many people without safe jobs losing their jobs and becoming unemployed.” Svensson, it should be noted, opposed the rate hike.

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Sweden

Moreover, economic growth has stagnated. After growing so strongly in 2010, Sweden’s gross domestic product began expanding more slowly in recent years and contracted in the first quarter of 2014 by 0.1% thanks in large part to falling exports.

As a result, Sweden reversed policy at the end of 2011 and started to pare its interest rate. The central bank recently cut the so-called “repo” rate by half a percentage point to 0.25%, more than analysts estimated. The hope is that out-and-out deflation will be avoided.

So the next time you’re inclined to ask the heavens why rates in America are still so low, remember Sweden and the scourge of deflation. Ask yourself if you want to take the risk that your debts (think mortgage) will become even more onerous.

MONEY The Economy

A Key Fed Official Says the Job Market is Just Fine. But is He Right?

Richard Fisher, president and CEO of the Federal Reserve Bank of Dallas
Richard Fisher, president of the Federal Reserve Bank of Dallas. Jose Luis Magana—Reuters/Corbis

With a little help from Jonathan Swift, Shakespeare, and World War II, Dallas Fed President Richard Fisher makes the case for why interest rates need to rise soon.

In between references to Shakespeare, beer goggles and Wild Turkey, Dallas Federal Reserve Bank President Richard Fisher— a member of the Federal Open Market Committee that sets the nation’s interest-rate policy— expressed concern Wednesday about the risks caused by the Fed’s ongoing stimulative policies.

Thanks to a dramatically improving jobs picture, according to Fisher, the Fed should not only cut off its bond-purchasing program (known as “QE3″) by October, but the central bank should also shrink its portfolio of assets and begin raising interest rates early next year or sooner.

Whether or not the economy can withstand monetary tightening — fewer jobs means fewer people able to buy stuff — is open for debate. The real question, though, is if the jobs picture is really that strong?

First some context.

In his colorful speech, Fisher, one of the Fed’s leading “inflation hawks,” reiterated his belief that the Fed’s rapidly escalating balance sheet (now at approximately $4.4 trillion) in combination with a near-zero federal funds rate has led to investors having “beer goggles.” (As Fisher explains it, “this phenomenon occurs when alcohol renders alluring what might otherwise appear less clever or attractive.”) This is what he says is happening with stocks and bonds, which are both relatively expensive.

To make his point Fischer quoted Shakespeare’s Portia in Merchant of Venice: “O love be moderate, allay thy ecstasy. In measure rain thy joy. Scant this excess. I feel too much thy blessing. Make it less. For fear I surfeit.”

Portia’s adjectives (joy, ecstasy and excess) describe “the current status of the credit, equity and other trading markets that have felt the blessing of near-zero cost of funds and the abundant rain of money made possible by the Fed and other central banks that have followed in our footsteps,” Fisher said.

Of course, the Federal Reserve hasn’t bought trillions of dollars of debt, and cut the main interest rate to nothing, for no reason. There was something called, you know, the Great Recession — the once-in-a-lifetime cataclysmic economic event from which the country is still recovering.

But, said Fisher, things are improving, especially in the labor market. Not only did businesses add almost 300,000 employees last month, but there are more job openings, workers are quitting more often and wages are rising. Is he right?

Let’s check out some graphs:

Job openings:

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Fisher is right that job openings “are trending sharply higher.” This time last year, there were a little less than 3.9 million job openings. Right now there are more than 4.6 million – an 18% increase.

“Quits”:

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The healthier an economy, the higher the number of employees who quit their job to either find another or start a new business. Therefore a higher so-called quits rate, means a healthier labor market.

Like job openings, the number of quits has been rising since bottoming out during the recession. The major difference though is that the number of job openings has almost reached pre-recession levels, while quits has not.

Wages:

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Fisher admits that wages aren’t growing “dramatically.” Nevertheless, he cites the Current Population Survey and the most recent National Federation of Independent Business survey to show that wages are on the rise.

However, wage data from the Bureau of Labor Statistics shows that Americans in the private sector are earning $24.45 an hour, only up 1.9% from last year.

But these three metrics aren’t the only metrics to gauge the health of the labor market.

Long-Term Unemployed:

l-t unemployment
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Before the recession, about 1.3 million workers were without a job for longer than 27 weeks. Today, that number is slightly more than 3 million. While that’s significantly better than the post-recession high of 6.8 million in August 2010, there are still a lot of workers who’ve been without a job for a long time.

“Long-term unemployment is still a significant source of slack in the economy and is accounting for a historically large share of the total unemployment rate,” says Wells Fargo Securities economist Sarah House.

Broader unemployment:

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And while the unemployment rate may signify the economy is moving closer to full employment, the picture is less sanguine if you look at a broader unemployment rate that takes into account the underemployed (part-time workers who want to work full-time) and discouraged workers. Before the recession that number hovered a little over 8%. It’s now 12.1%. And while it’s trending down, it’s not coming down fast enough. At least according to recent testimony by Federal Reserve Chair Janet Yellen.

Conventional wisdom says inflation will come when wages really start to rise. Some, like Fisher, think we’re getting really close to that point. But if you take into account wage data from the BLS and look at the millions of Americans who aren’t working to their full capacity, it’s not hard to see how tightening monetary policy might make life harder on lots of workers.

MONEY The Economy

The Shrinking Role of Wages

Senior woman looking at Social Security check
A social security check arrives in the mail Donald Higgs—Getty Images

As the population ages and workers get displaced, a smaller portion of income is derived from actual work.

For Americans, work is becoming less and less important.

Today, wages and salaries make up only 50.5% of overall personal income, according to a new Wells Fargo Securities report. That’s down from almost 60% in 1980.

You can blame some of this on changing demographics, including the aging of the population and government programs that direct transfer payments to certain groups.

Take Medicare and Social Security. In the beginning of 2007, 80% of people between the prime working ages of 25 to 54 was employed. Today that number is down to 76%.

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Source: St. Louis Federal Reserve and the Labor Department

While the Great Recession lowered demand for workers, “the aging of the baby boomers and longer life expectancies have pushed the share of the population age 65 and older to a record high,” writes Wells Fargo economists John Silvia and Sarah House.

Almost one in seven Americans is 65, according to the U.S. Census, compared to 12.4% in 2000. More Americans over the age of 65 means more Americans receiving Social Security and Medicare.

Then there’s help for the disabled and poor. “Increased eligibility and use of social insurance programs such as disability insurance and food stamps have also prompted the rise in transfer payments,” note Silvia and House.

Right now there are more than 14 million Americans who are deemed disabled by the Social Security Administration.

Consider this from NPR’s Planet Money’s excellent series on disability:

Part of the rise in the number of people on disability is simply driven by the fact that the workforce is getting older, and older people tend to have more health problems.

But disability has also become a de facto welfare program for people without a lot of education or job skills. But it wasn’t supposed to serve this purpose; it’s not a retraining program designed to get people back onto their feet. Once people go onto disability, they almost never go back to work. Fewer than 1 percent of those who were on the federal program for disabled workers at the beginning of 2011 have returned to the workforce since then, one economist told me.

Or take food stamps. Since 1969, the number of people on food stamps has increased by a factor of 16.

The share of income derived from transfers has increased from 12.5% in 2000 to 17.3% today, according to Wells Fargo Securities.

A lousy job market in the aftermath of the recession has left millions without work — 36% of today’s unemployed have been without a job for over 27 weeks, compared to 12.1% in 2000. And that abundance of available labor, writes Silvia and House, “has kept wage growth muted, restraining labor income even as hiring has improved.”

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Sources: St. Louis Federal Reserve and the Labor Department

For the overall economy, “the general diversification of income sources adds to the stability of consumer spending over time,” House says. “In particular, transfer payments have becoming an increasingly important share of income and have helped to smooth income/spending throughout the business cycle and Americans’ life cycle.”

MONEY The Economy

The Return of the Most Interesting Man on Wall Street

Paul McCulley
I don't always call for stimulus, but when I do it's monetary AND fiscal. Lori Shepler—Reuters

Paul McCulley returns to PIMCO as chief economist. Here's how he explains the mysteries of the Fed and ultra-low interest rates.

Pimco, manager of nearly $2 trillion in assets and home to Bill Gross and his massive $230 billion Pimco Total Return bond fund PIMCO FDS PAC INVT TOTAL RETURN A PTTAX -0.2752% , annouced last week that it has brought back Paul McCulley. McCulley, who made his name at the firm with his sharp commentaries on the Federal Reserve, will be Pimco’s chief economist. For 100 days per year.

The return of McCulley is attracting attention in part because of recent management turmoil at Pimco, which saw former co-CEO Mohamed El-Erian clash with Gross and leave unexpectedly. Reports also mention McCulley’s imaginary Q-and-A with his pet rabbit and recent unusual hair. (He’s since cut it. The photo here is from 2011.)

But McCulley is also a man with unusual ideas for a Wall Streeter* (*West Coast Division—Pimco is based in Orange County). Those ideas will certainly be of interest to investors in Earth’s biggest bond fund. But they also point to a different way of thinking about what the ever-mysterious Federal Reserve has been up to.

In his time away from Pimco, McCulley was chair of fellows at a group called the Global Interdependence Center, where he co-wrote a pair of unorthodox papers on the future direction of both the Fed’s interest-rate setting (monetary policy, in the jargon) and government spending (fiscal policy.)

Here’s the conventional wisdom on what the Fed has been doing: By holding interest rates very low, by buying up massive amounts of bonds in operations called “quantitative easing,” and by communicating that it is really, really, super serious about keeping rates low until inflation runs at at least 2% and unemployment falls under 6.5%, it is sending a message to the markets. This will encourage people to buy stocks, to borrow, to invest in businesses, and to spend.

McCulley’s argument (at least in early 2013 when he wrote the most recent paper) is that this is only half the game. When the private sector is still trying to climb out of a debt hole and the Fed has already cut rates near zero, the economy needs the public sector to pick up some slack. “Fiscal ‘irresponsibility’ (running large deficits despite large deficits as far as the eye can see) may in fact be far more important at the zero bound than monetary irresponsibility,” McCulley and coauthor Zoltan Pozsar write. In their language, “irresponsibility,” or unorthodoxy, is a good thing under the circumstances.

They say what the Fed has really been doing (or maybe should have been doing—it’s not clear) with its extraordinary actions is to send a message to Congress and the White House: “Please, go spend some money! Even if it triggers some inflation and blows up the deficit, we won’t get in your way.” In fact, McCulley and Pozsar write, the central bank should have gone further, making clear it would essentially fund deficits by keeping up QE.

If that was ever the message, it was not received. In fact, the deficit has been falling, and recent battles between Congressional Republicans and the President over the debt ceiling have put an end to any talk of fiscal stimulus.

In Europe, the other big engine of the global economy, policymakers are if anything even more austerity minded.

So instead of worrying that the Fed has gone too far with QE and is about to ignite inflation, a McCulley-ish view of the world has central banks basically pushing on a string. If you believe that, you’d think the Fed’s going to be keeping rates low for some time to come. And you’d probably be inclined to ignore the constant refrain that Treasury bonds, with their super low yields, are a bubble just waiting to burst.

Beyond the stock and bond markets, you’d expect sluggish growth ahead. Unemployment has dipped to 6.3%. But some worry that too much of this is due to fewer people looking for jobs.

Pimco’s latest market outlook has been for a “new neutral”—that is, a world where growth and inflation never really take off in a big way, but then neither do interest rates, and investors can expect modest returns. Sounds like they’ve been keeping tabs on McCulley’s writing and thinking. Does that mean the funds will stay bullish on bonds for a while? Maaaaybe. What a firm like Pimco says in public is one thing. They make their money by timing the turns from the status quo to the next big move. They probably won’t tell you about it first. (Pimco has had a mixed—at best—record of getting interest rate and inflation moves right in recent years.)

Pimco has told its investors that a lot of the “new neutral” story is built into today’s high asset prices and low bond yields. So even at face value, this isn’t so much a bullish case as an argument that risks aren’t as high as some people worry they are. In other words, the Pimco view is that we are not yet set up for a repeat of the 2007-2008 “Minsky moment”—a term McCulley coined for the tipping point when complacent investors discover that they took to much risk. (He’s also been credited with the term “shadow banking.” Like I said, interesting guy.)

Beyond what it means for Pimco’s shareholders it should be interesting to see how McCulley, whose new role all but guarantees him a guest seat on CNBC and the ear of every financial reporter, affects public debate about fiscal and monetary policy. Imagine Paul Krugman sitting besides a $2 trillion portfolio.

MONEY The Economy

5 Reasons the Economy is Not Headed for Recession

Growth will soon resurface. Cultura RM/Liam Norris—Getty Images

Despite disappointing GDP numbers, the economy is firmly headed higher.

The economy may have slipped out of gear, but it’s not in reverse.

True, a government report released late last week showed that the U.S. economy did actually contract at an annual rate of 1% at the start of the year, which was much worse than consensus forecasts for a 0.5% decline. That marked the first time gross domestic product had actually shrunk since the first quarter of 2011.

This would explain why market interest rates have been falling so much lately — yields on 10-year Treasuries have sunk from 3% to 2.53% this year. In periods of slow or no growth, investors routinely favor fixed income over equities, which pushes bond prices up and yields down.

Before you start bandying about the “R” word, though, let’s keep things in perspective.

A recession is loosely defined by two consecutive quarters of GDP contraction (actually, it’s officially determined by a group of economists at the National Bureau of Economic Research). The economic data released last week represent just one quarter of activity. Plus a survey of 42 economic forecasters by the Federal Reserve Bank of Philadelphia found strong expectations that the economy snapped back in the second quarter. In fact, the economy is thought to have expanded 3.3% in the spring.

What’s more, forecasts for GDP growth for the remainder of the year are on the rise. In the third quarter, the economy is now expected to expand 2.9%, not 2.8% as was previously thought, according to the Philly Fed survey. And fourth-quarter GDP is expected to rise 3.2%, up from earlier forecasts of 2.7%.

Also, there are at least five economic indicators that would confirm the economy is on much surer footing than either the first-quarter GDP report or bond yields would indicate. Among them:

1) The manufacturing economy is improving.
If the economy were on the verge of reversing course, you would at least start seeing the nation’s industrial sector flatten out. Yet as you can see below, that’s not happening.

US Industrial Production Index Chart

US Industrial Production Index data by YCharts

Nor do investors expect it to, which explains why Wall Street continues to bid up shares of economically sensitive sectors like industrials and basic materials faster than the broad market.

^SPX Chart

^SPX data by YCharts

2) Consumers are getting stronger, not weaker.
If consumer spending represent two thirds of the nation’s GDP, then it would be difficult for the economy to slip into recession if households are loosening up their purse strings. Well, retail sales for discretionary purchases (things you don’t really need) with cash has been growing 2%. Meanwhile, discretionary spending on items requiring financing is up much more—5.6%. “Consumers are flexing their muscles again,” says Jack Ablin, chief investment officer for BMO Private Bank.

3) Small business confidence is growing.
One sign the economy is not in dire shape is that “corporate confidence—even among smaller companies—is improving,” says Liz Ann Sonders, chief investment strategist at Charles Schwab. Small companies are often the canaries in the coal mine of a lousy economy. A year before the economy crashed into recession in December 2007, the NFIB Small Business Optimism was already in decline (in fact, it had been falling gradually since the end of 2005). So far this year, the index has climbed, from a reading of 91 in February to 95.

4) Big business is also gaining confidence.
Not only can you see that in booming merger & acquisition activity, but corporations are slowly but surely adding to their payrolls.

US Change in Nonfarm Payrolls Chart

US Change in Nonfarm Payrolls data by YCharts

5) Economic signs that normally offer clues about future activity are running positive, not negative.
The Conference Board’s index of leading economic indicators “has climbed for the twelfth time in 13 months to yet another new cyclical high,” notes Ed Yardeni, president and chief investment strategist at Yardeni Research.

By contrast, in the 12 months leading up to the start of the 2007-2009 recession, the leading economic indicators index had been precipitously falling.

So buck up.

MONEY stocks

Profit Growth Is Slipping and That’s Not Good for Stocks

As corporate earnings growth slows, stock valuations are climbing well above historic standards.

The fact that companies have been consistently generating record profits in recent years has certainly been a boon to the S&P 500 S&P 500 INDEX SPX -0.2786% .

Unfortunately, there will come a time when corporate earnings growth will inevitably slow — and that time may be now.

A government report released in late May found that overall corporate profits actually slumped in the sluggish first quarter, when a brutal winter weighed on business activity. The Bureau of Economic Analysis says that a key measure of corporate earnings fell 3% in the first quarter, compared to the fourth quarter of 2013. Versus the same period last year, profits slumped much more — 9.8%. This is true for both financial and non-financial companies.

Now, there are a variety of ways to measure the health of profits. In the private sector, economists often look at overall earnings growth for companies in the S&P 500.

By this measure, profits are still climbing, but the rate of that growth is slowing noticeably. In fact, expectations for both first quarter and second quarter earnings have been cut in half in less than a year.

Falling earnings chart
Source: S&P Capital IQ

A big reason why is that the economy is not rebounding as strongly as was thought, and overall corporate revenues are growing only modestly.

Sales Dwindling
Source: Thomson Reuters

Yet stock prices have been surging faster lately than the rate of both earnings and revenue growth. “Over the past few years multiple expansion has been the key factor lifting equity market levels higher,” notes Tom Stringfellow, chief investment officer for Frost Investment Advisors.

Forward PE ratios
Note: P/E based on forecasted profits over next 12 months. Source: Bloomberg

Indeed, virtually every part of the stock market is now trading at higher price/earnings ratios — based on forecast profits over the next 12 months — then they have historically. And that’s never a good sign.

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