Diane Swonk is chief economist for Mesirow Financial, a financial services firm based in Chicago. She is past president (and the youngest president ever) of the National Association for Business Economics (NABE), a title shared by the likes of former Federal Reserve Chairman Alan Greenspan. Often witty, always insightful and never one to hold her tongue, Ms. Swonk’s analysis is seen regularly on television shows such as CNBC’s Squawk Box. Amid breaking news from the Middle East, she paused to answer five pressing questions about the economy.
Oil price increases are nothing more than attacks on consumers! -Swonk
1. There is a lot of turmoil in the Middle East, from Egypt to Libya and beyond. How is it affecting the U.S. economy?
Swonk: Many people had wanted to see democracy in the Middle East but the Middle East is not a place that understands democracy the same way that we do in the United States. The only parties that are organized enough to run government at this stage of the game are the military and the religious fundamental organizations that would prefer a theocracy rather than a democracy. That’s what’s left a lot of uncertainty in the financial markets about the Middle East. In Libya unlike Egypt the military is very tribal and has not been supported as heavily by the United States as the Egyptian military. As tribal factions fall apart Libya could fall into a state of anarchy, and if that were to occur it would jeopardize oil supplies, which they do export heavily. Saudi Arabia could make up for that, but it would take some time.
In the US oil price increases are nothing more than attacks on consumers. And when you don’t have a lot of wage gains many consumers react to oil price increases by cutting back on their consumption of gas once it hits a certain level—most notably about $3.50 per gallon of regular. Secondly, they start cutting back on discretionary purchases. Now the payroll tax, which was expanded when the tax cuts were extended in December, that is going to end up paying for a lot of consumption of gasoline at the pump, which isn’t exactly what we wanted. We wanted it to pay for discretionary purchases and broad-based gains in consumer spending. So it won’t really go right to the bottom line of helping consumers spend more.
Crockett: Is the turmoil there primarily impacting the cost of oil or are there broader effects on the US economy that we ought to be concerned about?
Swonk: The initial impact is the oil. But of course with the Middle East there are always secondary effects. Not knowing what’s gong to happen with the state of leadership or lack thereof in many of these economies may change our priorities on security. We’re trying to cut nonessentials in defense as we rein in federal budget deficits. There’s a nationwide consensus not to waste money on defense. But this will move many security issues back to the forefront. Body scan machines are being curtailed because they don’t really seem to be doing what many people hoped in terms of curtailing the risk of a terrorist attack on a plane. Depending on what happens in the Middle East, these things could have ramifications on what our spending priorities are as a nation.
Demand has come back but not because the U.S. is strong. -Swonk
2. Can you explain the basic economic theory behind what happens to demand that causes the cost of oil to rise and how that translates to the consumer?
Swonk: This has been one of the biggest issues for the US because oil prices were rising before we had all of this [unrest] break in the Middle East in the last several weeks. It’s because we had two things going on. One, there was a lack of investment when oil prices were very low during the recession so many of the large oil companies did not invest aggressively. We also had a major oil spill in the gulf and a moratorium on drilling in the gulf, which slowed down supply and created a lot of uncertainly about how much investment many of these oil producers should be doing. On the other side of it demand has come back quite dramatically not because the U.S. is so strong or Europe is so strong. They aren’t. It’s because the developing world—places like China and India are coming back rapidly. Most notably we’ve seen growth rates in many emerging markets meet or exceed pre-crisis growth rates, which means they are consuming a lot more energy. So it’s really out of our hands. We are paying the consequences of other countries’ strong demand. And some supply shocks have erupted.
Don’t blame Bernanke… He doesn’t have power over Mother Nature. -Swonk
3. Prices for commodities such as wheat and cotton are on the rise, causing a ripple effect in rising costs for businesses and ultimately price increases for consumers. What’s behind this phenomenon?
Swonk: The run-up in commodity prices is similar to the run-up in oil prices. The first thing that people do in emerging markets when they make more money is they consume more food. These are starving economies so as they moved up the food chain the demand for food globally went up and the demand for many basic commodities went up. At the same time the world saw extraordinary supply shocks. We had freezes in Mexico that damaged many crops that we import—tomatoes and cucumbers, for example. Then we’ve seen the cotton crops that were destroyed by floods, and earthquakes in Australia—a major commodity producing economy. This disrupted supply at the same time that demand was going up. Now many people would like to blame [Federal Reserve Chairman] Ben Bernanke for this [and his efforts] to stimulate our economy. I find that to be a simplistic and shallow answer. I don’t think he has the power over Mother Nature to cause these world calamities that we’ve seen. As the Fed bought $600 billion in treasury bonds we’ve got $4 trillion a day in trading going on in currencies worldwide! [The Fed spend] is a small drop in the bucket of global currency markets in one of the most liquid currencies that exists: The US dollar.
Crockett: These increases will certainly trickle down to the consumer. Is that an extraordinary threat to the economic recovery?
Swonk: I don’t think it’s an extraordinary threat. It is a headwind to the US economy, which frankly doesn’t need any. We’re regaining momentum but we’re still not going fast enough to create enough jobs for those coming into the labor force, let alone to absorb all of those people who had lost their jobs during the recession. Even as private sector employment growth nearly triples the pace we saw in 2010, we’re still going to be 4 million jobs in the hole from the recession. This has been a long and painful process. Anything that adds a headwind is certainly unwelcome news. It’s important to remember that commodity prices are only 10% of the input costs of goods. Consumers are substituting things like spaghetti and noodles and rice, foods that have not gone up in price, for vegetables and other more expensive products.
Realtors may have severely underestimated the decline in home sales. -Swonk
4. The Consumer Confidence Index rose in February to its highest point in three years and yet home prices are falling in most big cities. What does this mean for the state of the economy?
Swonk: It’s important to put consumer confidence in context. It’s still more consistent with recession levels than with recovery levels. Second, almost all of the increase in consumer confidence came in expectations for the future. Remember, when the survey was taken we had broader tax cuts, the market was rallying and we didn’t have the Middle East breaking apart yet. Almost all of the improvement has come from higher income households, who are least sensitive to things like commodity and oil prices going up. They also have more diversified portfolios. Their home isn’t their largest asset. They’ve got wealth and they were able to double down when the market dipped. We also now have information that the national association of realtors may have severely underestimated the decline in home sales that we saw during the housing market crisis since 2007, and they are underestimating the inventories that are still on the market to sell. Realize that there are homes that have been sitting and have not been put into foreclosure yet, and when they do go on the market they might not be inhabitable. This means there will be further downward pressure on home prices, probably in the range of 3%—not counting foreclosure. Add to that a lot of inventory of unsold homes that are competing with the new home market you realize why we still have new housing starts at close to record lows. That hurts because housing construction is where the bang for your dollar is in terms of jobs, and it’s hard to get that momentum going again until you clear out a lot of the existing housing inventories.
“Investors are mad and saying, “Give it back!” -Swonk
5. If you look into your crystal ball what sort of employment picture do you see for the future, say, the next 6 to12 months?
Swonk: We do expect employment to improve. It looks like it’s firming across a broad spectrum of surveys including business confidence. Let’s face it: Who’s got the money right now? Large multinational businesses. And unlike the last two years when they hoarded cash they now have institutional investors—the pension funds that you’ve been paying into—that are now mad and taking seats on boards and saying, “Give it back!” Either give it back in the form of dividends or redeploy it. So we think investment is likely to pick up. We’re seeing exports very robust and you will see some jobs out of that. But even if we triple the pace of 2010’s [job growth] in 2011 you’re still in the hole by quite a bit from the recession. So this is still a sub-par recovery even as the economy reaccelerates.
Crockett: But we are we starting to see the unemployment rate begin to drop pretty impressively, right?
Swonk: We do have a different unemployment rate now. But remember they [the government] changed the base of the unemployment rate in January. It’s one of those things that most people didn’t notice. That’s the reason that the unemployment rate fell to 9%. You can’t compare it [to earlier months] it’s a discontinuous series. So that’s lowered [economists’] forecasts of what the unemployment rate will be at the end of the year. We didn’t really change our view of the economy all that much. So if we hit 8.4% by the end of the year it’s not like anybody is going to pop champagne corks over that.