A sharp contraction in labour income has many negative effects on the economy and financial markets, says Nouriel Roubini.
Recent data suggest that job market conditions are not improving in the United States and other advanced economies. In the US, the unemployment rate, currently at 9.5 per cent, is poised to rise above 10 per cent by the fall. It should peak at 11 per cent some time in 2010 and remain well above 10 per cent for a long time. The unemployment rate will peak above 10 per cent in most other advanced economies, too.
These raw figures on job losses, bad as they are, actually understate the weakness in world labour markets. If you include partially employed workers and discouraged workers who left the US labour force, for example, the unemployment rate is already 16.5 per cent. Monetary and fiscal stimulus in most countries has done little to slow down the rate of job losses. As a result, total labour income — the product of jobs times hours worked times average hourly wages — has fallen dramatically.
Moreover, many employers, seeking to share the pain of recession and slow down layoffs, are now asking workers to accept cuts in both hours and hourly wages. British Airways, for example, has asked workers to work for an entire month without pay. Thus, the total effect of the recession on labour income of jobs, hours and wage reductions is much larger.
A sharp contraction in jobs and labour income has many negative consequences on both the economy and financial markets. First, falling labour income implies falling consumption for households, which have already been hard hit by a massive loss of wealth (as the value of equities and homes has fallen) and a sharp rise in their debt ratios. With consumption accounting for 70 per cent of US GDP in the US, and a similarly high percent in other advanced economies, this implies that the recession will last longer, and that economic recovery next year will be anaemic (less than 1 per cent growth in the US and even lower growth rates in Europe and Japan).
Second, job losses will lead to a more protracted and severe housing recession, as joblessness and falling income are key factors in determining delinquencies on mortgages and foreclosure. By the end of this year about 8.4 million US individuals with mortgages will be unemployed and unable to service their mortgages.
Third, if you plug an unemployment rate of 10 per cent to 11 per cent into any model of loan defaults, you get ugly figures not just for residential mortgages (both prime and subprime), but also for commercial real estate, credit cards, student loans, auto loans, etc. Thus, banks losses on their toxic assets and their capital needs will be much larger than recently estimated, which will worsen the credit crunch.
Fourth, rising job losses lead to greater demands for protectionist measures, as governments are pressured to save domestic jobs. This threatens to aggravate the damaging contraction of global trade.
Fifth, the higher the unemployment rate goes, the wider budget deficits will become, as automatic stabilisers reduce revenue and increase spending (for example, on unemployment benefits). Thus, an already unsustainable US fiscal path, with budget deficits above 10 per cent of GDP and public debt expected to double as a share of GDP by 2014, becomes even worse.
This leads to a policy dilemma: rising unemployment rates are forcing politicians in the US and other countries to consider additional fiscal stimulus programmes to boost sagging demand and falling employment. But, despite persistent deflationary pressure through 2010, rising budget deficits, high financial-sector bailout costs, continued monetisation of deficits, and eventually unsustainable levels of public debt will ultimately lead to higher expected inflation — and thus to higher interest rates, which would stifle the recovery of private demand.
So, while further fiscal stimulus seems necessary to avoid a more protracted recession, governments around the world can ill afford it: they are damned if they do and damned if they don’t. If, like Japan in the late 1990s and the US in 1937, they take the threat of large deficits seriously and raise taxes and cut spending too much too soon, their economies could fall back into recession. But recession could also result if deficits are allowed to fester, or are increased with additional stimulus to boost jobs and growth, because bond-market vigilantes might push borrowing costs higher.
Thus, even as mounting job losses undermine consumption, housing prices, banks’ balance sheets, support for free trade, and public finances, the room for further policy stimulus is becoming narrower. Indeed, not only are governments running out of fiscal bullets as debt surges, but monetary policy is having little short-run traction in economies suffering insolvency — not just liquidity — problems. Worse still, in the medium turn the monetary overhang may lead to significant inflationary risks.
Little wonder, then, that we are now witnessing a significant correction in equity, credit and commodities markets. The irrational exuberance that drove a three-month bear-market rally in the spring is now giving way to a sober realisation among investors that the global recession will not be over until year end, that the recovery will be weak and well below trend, and that the risks of a double-dip W-shaped recession are rising.
Nouriel Roubini is Professor of Economics at the Stern School of Business, New York University, and Chairman of RGE Monitor (www.rgemonitor.com)