Current State of the Economy

Interviewee:  Professor Elijah Brewer, DePaul University Dept. of Finance.

Interviewer:  Marc J. Grens, Alpha Strategies

Thursday, March 29^th

What is your general outlook on the economy & unemployment over the next 24 months?

-          Given that the consensus forecast for real GDP is below average after a normal recession at 2.3% for 2012 and 2.8% for 2012, these numbers are not nearly fast enough to bring down the unemployment rate.  The general rule of thumb is that the real GDP growth needs to exceed 3% after a recession in order to traditionally lower the unemployment rate overtime. 

Another issue to take into consideration with the unemployment rate is that once the overall markets start to improve, the previously discouraged unemployed and underemployed will again re-enter the marketplace to seek jobs only to exacerbate the unemployment rate even further.  With that in mind, my outlook is slow continued growth in a sluggish labor market.

Additional issues still persist overseas in the Eurozone regarding their current debt problems as they are continuously finding ways to kick the can down the road.  This general uncertainty is only making financial institutions and forecasters hesitant to see a brighter future and increase spending to bring down the unemployment rate. 

On a good note, we are currently starting to see the non-farm payroll numbers increasing to the tune of 200,000 jobs per month for the past three months ending with February.  These numbers were also similar the same time in 2011; however, the continued Eurozone issues may have put a halt to any potential momentum the jobs market in the U.S. may have noticed.  Assuming a continued trend in the above average non-farm payroll numbers, then this be a positive sign for growth in GDP.

However, with the overwhelming debt in the Euro Sovereign nations along with the massive deficits in the U.S., the hope for growth is dim until the markets start to believe that the major countries in the world have their debts under control.

Regarding the components that make up the annual GDP, specifically in the U.S., it is typical residential investment makes an approximately contribution of 0.5% to the annualized GDP after a recession; however the annual contribution has been close to “zero”.  Assuming residential investment was contributing at its average of 0.5%, real GDP would be over 3%, therefore, the unemployment rate would start to decline dramatically faster than the present rate.

With this is in mind, it’s no wonder that the Federal Reserve has been artificially keeping current interest rates much lower than normal in order to make it more enticing for borrowers to obtain financing for the purchase of a residential home.

However, the hope for new homeowners to enter the marketplace has not happened quite as much as the Federal Reserve and other participants would like.  Several problems equate to this such as current underwriting standards at most commercial banks are way too tight providing those that historically could have received loans, however, cannot obtain a loan.  Also, since the lending standards have tightened up in banks after the financial crash, the length of time to go through the underwriting process has dramatically increase as the level of scrutiny has also increased against borrowers.

Until the residential investments start to see a positive turn, I wouldn’t expect the Federal Reserve to make any major policy shifts in interest rates.

What’s your outlook on inflation in near and intermediate term?

According to the recent economic data, inflation has been relative mild; however, we’re starting to see increases in gas prices, which can be a leading indicator for increasing overall prices in the intermediate term.  One thing to note is how much that will impact household discretionary income, which may keep inflation at bay in the meantime.  If we can weather the storm (increased gas prices) over the next 6 months, that can be a positive sign of improvement for the overall growth of the economy.  All things being consider and if we take out food & energy in the equation, the inflation number & outlook is very mild with little short-term concerns for inflated prices.

Let’s talk about your thoughts on the banking sector:

Presently, the commercial banks have amassed the largest amounts of cash in deposits at almost $1.7 trillion dollars (before 2008, it was around $2 billion).  What this means is that the banking sector has a ton of cash on hand that is readily available for the business and consumers in our country for investment and growth, however, the lack of certainty in regulations and fiscal policy has had a negative impact on the willingness of many bankers to hand out this cash in the form of loans or investments.

Relatively speaking, the available credit in the marketplace has been the same as pre-2008; however, the following is why banks are reluctant:

a)      Commercial banks still have a large number of toxic assets on their balance sheets making it more difficult for banks to want to lend in this environment.

b)      Tightening lending standards due to the “pendulum effect” resulting from the loose standards pre-2008. 

c)      Uncertainty in regulations and lack of management incentives to take risks by increasing their lending.

There is some good news to report; residential & commercial loan tightening standards are flat.  What this means is that the number of banks that are loosening standards are equal to the number of banks that are tightening standards.  Only a few years ago, this trend was very negative where most banks were tightening their standards making if very difficult for borrowers to obtain a loan.  However, this figure does not distinguish between the degree to which banks of various sizes that are either tightening or loosening their lending standards. 

Can you explain the ties between market confidence and recent legislation in the finance and banking sector?

Relative to the uncertainty of the banking sector, the real GDP numbers following the economic recessions in ’81-82 and ’74-75 were far greater than the real GDP thus far that has followed the ’08 recession.  The present problems of the market growth & confidence are a partial function of the design of the rules of Dodd-Frank.  Ultimately, the impact of Dodd-Frank act is creating uncertainty among banks that want to lend and take logical risk.  What this tells us is that the quantity of rules of Dodd-Frank is incentivizing banks to take less risk and provide fewer loans to the market, which may stint real GDP growth.

The primary issue with the Dodd-Frank act is that is doesn’t give enough broad-stroke powers to regulatory bodies to govern based upon their expertise in each respective area of the banking under those agencies.  Personally, I would not have passed the Dodd-Frank until the Financial Commission (the organization created to analyze the historic events responsible for the financial crisis).  Dodd-Frank was signed into law in July 2010, however, the Financial Commission did not produce its full due diligence report on the problems in the financial markets until December 2010, which was several months after the bill was signed.  When a bill like the Dodd-Frank act was passed in this way, it tends to leave out many important details, for example, it doesn’t address fixing the issues within the money market fund industry (i.e. Prime Money Market fund that “broke the buck” that resulted in a short-term shock to the demand for commercial paper) Presently, Dodd-Frank act mentions nothing about this, although the Securities and Exchange Commission is working on rules to strengthen the safety of investors funds in money market funds.  In addition, the Dodd-Frank act does nothing to address protecting customer accounts like the $1.6 billion lost from the catastrophic implosion of balance sheet of MF Global.

An example of a way to combat another default of a large financial institution, like MF Global, is to seriously alter the risk management internal controls.  The Chief Risk Officer who oversees these internal controls should report directly to the Board of Directors, and not the CEO of the firm.  If the Chief Risk Officer is reporting to the Board of Directors, he or she will have the incentive to report more accurate information and not withhold items that the CEO would have him or her withhold, anyway.

Back to the financial regulations at hand, these types of issues are still not being addressed and the can is still being kicked down the road.  At some point, our legislators will not be able to kick the can down the road where financial firms will need to be accountable for their actions (i.e. Long Term Capital Ma   nagement, AIG bailouts).  These decisions should be made based upon unbiased merit directly or indirectly relating to the systemic nature of their implicit default.

How do you feel the horizon of the markets will impact the DePaul Finance graduate?

In the foreseeable future, I believe it will be a little difficult to obtain jobs in the financial services industry due to a very slow growth in the sector, in particular, and in the overall economy, in general.  For instance, many of the largest banks like Bank of America and Citigroup have been laying off employees to the tune of several thousand each time a layoff has been announced.  This doesn’t make is easier for the finance job candidate with little to no experience to obtain a position when he or she is competing against someone with 10+ years’ experience.  Those unemployed will need to find finance jobs first before most of the market will then hire entry-level or those with little to no experience (as in many students in Finance).

In addition, most companies are taking the “let’s wait & see” attitude when it comes to hiring.  As I mentioned earlier, the fact that their still a ton of uncertainty in the economy, legislation, and future prospects of profits in the industry, employers are not incentivized to take on additional risk and start hiring new candidates without an improvement in economic conditions.

However, many financial companies have significantly increased their internship opportunities in finance and banking, specifically for those undergraduate finance students with no real work experience.  Internship opportunities tend to be an excellent way to get into the financial industry where otherwise entry-level candidates wouldn’t be able to get in.