Goldman’s top economist explains his big call for the U.S. economy
Joe Weisenthal, Business Insider
Dec 12, 2012
In a recent report, Goldman’s top economist Jan Hatzius predicted that finally, the U.S. would see a real growth acceleration in the second half of 2013.
There are three great reasons to listen to Hatzius:
1. He’s the top economist at Goldman Sachs. That alone is a reason to take him seriously.
2. He called the economic downturn. Remember, he got pilloried in 2007 by Ben Stein for saying that housing was going down, and that the economic ramifications would be significant.
3. He has a framework for analyzing the economy that’s rare among Wall Street economists.
At the core of his call — which was made in a note titled
The US Economy in 2013-2016: Moving Over the Hump — was this simple chart:
The chart demonstrates a critical economic concept: Government deficits (the grey line) are essentially the mirror image of private sector savings (the dark black line). When the private sector tries to save money aggressively (as happened during the crisis) the government deficit will inevitably explode (as happened). Periods associated with small government deficits (such as the late ’90s) are associated with extreme private sector leveraging.
The key to understanding the economy, and forecasting growth, is to think about which sectors are increasing and decreasing their savings.
In a 30-minute conversation with Business Insider conducted last Friday, Hatzius explained:
“…every dollar of government deficits has to be offset with private sector surpluses purely from an accounting standpoint, because one sector’s income is another sector’s spending, so it all has to add up to zero. That’s the starting point. It’s a truism, basically. Where it goes from being a truism and an accounting identity to an economic relationship is once you recognize that cyclical impulses to the economy depend on desired changes in these sector’s financial balances.”
Hatzius is bullish on the U.S. economy starting in the second half of 2013, because finally he expects private releveraging to occur at a nice clip, and to not be counteracted by a fiscal drag. Says Hatzius:
“If the busin
ess sector is basically trying to reduce its financial surplus at a more rapid pace than the government is trying to reduce its deficit then you’re getting a net positive impulse to spending which then translates into stronger, higher, more income, and ultimately feeds back into spending.”
He has a specific explanation and numbers in mind, to explain the private sector’s inclination to reduce its savings, and spend more.
“Since mid-2009, that surplus has gradually come down as businesses and households have gotten closer to where they need to be from a long-term balance sheet perspective. They’ve paid down debt, they’ve eliminated the excess supply of housing, and that’s basically allowed them to reduce the financial surpluses that they run. They’re still running large surpluses – still 5.5 to 7 percent of GDP, but they’re no longer as large. We expect those figures to come down as the balance sheet adjustment process makes further strides and that’s an underlying source of boost to the economy that’s happening on the one side.”
Of course, Hatzius’s bullishness on the private sector’s impulse to spend more is tempered by the fact that we’re going to see some form of austerity early in 2013, even if there’s a deal on the fiscal cliff.
And if there’s no deal on the fiscal cliff, then there is major cause for worry. While things might be okay if a deal is agreed to early in January, the ongoing confidence shock as the fight wore longer into the year, would be a problem. If we go into February without a deal?
“…I think the economy will be contracting, and potentially contracting pretty rapidly. It’d be a very unpleasant environment.”
Suffice it to say, Hatzius is not to keen on the push to rename the “Fiscal Cliff” the “Fiscal Slope” in order to take the urgency out of getting a deal by the end of the year.
Among other topics in our discussion: The future of Fed policy (he thinks there’s a high probability, but no guarantee, that the Fed will adopt an “Evan’s Rule” early in 2013), why business investment has slowed down dramatically, when interest rates will finally rise (probably the end of 2013), when the Fed will tighten policy (no sooner than 2016!), and whether monetary policy regime change will work in Japan.
The full transcript of our discussion is below the dotted line. Thanks to Lucas Kawa for the transcription.
------------------------------------------------------------------------
BI: In your recent note you said that starting last year, you introduced your clients to the notion of “financial balances model,” that private sector surpluses were offset by government sector deficits, and that they mirrored one another. Explain this chart and how you came to recognize the importance of it.
HATZIUS: There is an accounting identity which is issued, if you start with the global economy, to simplify it, that every dollar of government deficits has to be offset with private sector surpluses purely from an accounting standpoint, because one sector’s income is another sector’s spending, so it all has to add up to zero.That’s the starting point. It’s a truism, basically.
Where it goes from being a truism and an accounting identity to an economic relationship is once you recognize that cyclical impulses to the economy depend on desired changes in these sector financial balances.
If the business sector is basically trying to reduce its financial surplus at a more rapid pace than the government is trying to reduce its deficit then you’re getting a net positive impulse to spending which then translates into stronger, higher, more income, and ultimately feeds back into spending.
Conversely, if the business sector reduces its desired surplus by less than the government sector tries to reduce the budget deficit, then you end up with cyclical weakness. It’s a little heavy-going, to put this into words, and can be challenging.
There’s a reasonable amount of jargon involved (ex post, ex ante type of stuff), and I generally try to avoid having too much jargon and too much heavy going in the sort of things that we write, but in this particular case it is useful and worthwhile to wade through this a little bit. It’s an exception, but I think it is useful in this case.
BI: In your recent note, “Moving Over The Hump” you say that in the second half of 2013, we’re going to switch over to a level of above-trend growth that we haven’t seen since the financial crisis hit. What’s the switch, and how does it relate to this chart?
HATZIUS: The main thing is that there’s a sort of continued improvement in the private sector, in the sense that the private sector went to running extremely large financial surpluses during the crisis. In the middle of 2009, households and businesses spent 9 percent of GDP less than they earned, meaning they were running a 9 percent of GDP financial surplus.
Since mid-2009, that surplus has gradually come down as businesses and households have gotten closer to where they need to be from a long-term balance sheet perspective. They’ve paid down debt, they’ve eliminated the excess supply of housing, and that’s basically allowed them to reduce the financial surpluses that they run. They’re still running large surpluses – still 5.5 to 7 percent of GDP, but they’re no longer as large. We expect those figures to come down as the balance sheet adjustment process makes further strides and that’s an underlying source of boost to the economy that’s happening on the one side.
On the other hand though, the government has moved to increasing the fiscal drag. The pace of fiscal consolidation has picked up. Most of the fiscal consolidation that we’ve seen so far has been in the state and local sector.
As we move into 2013, we’ll see a big pickup in fiscal consolidation, probably, in the federal sector, and early 2013 we’re going to be at 1.5 percent of GDP of fiscal drag and I think that is going to make the economy quite weak.
Our baseline is not recessionary weak but nevertheless, it is going to look quite weak. Beyond that though, to get to answering the question, beyond the first half of 2013, we would expect the pace of fiscal drag to diminish, and as it diminishes that should lead to some acceleration in models over the next couple of quarters here.
BI: Speaking about the private sector specifically – I understand the argument that households are repairing their balance sheets for various reasons (ex. the housing bust is over) – but what’s your take on the corporate side of the private sector? What will prompt the corporate sector to spend more money and reduce its surpluses?
HATZIUS: There’s been some of that already. Over the last couple of years, the corporate sector – outside the financial sector – didn’t go into the crisis with big, heavy, over-leveraged balance sheets, but there’s been sort of improvement in the quality of balance sheets, earnings have been strong, and so the corporate sector has reduced its surpluses a bit as well. There has been, more recently, greater weakness in corporate spending over the past 6 months.
We would attribute some of that to fears about the fiscal cliff and fears of policy uncertainty shock in late 2012 – early 2013. I think if that’s the right diagnosis and you do get some kind of a deal and some resolution to the uncertainty, then that might also mean that you get some pent-up demand being released in the for profit sector. My expectation would be that you get a recovery, provided you do get the deal.
BI: Do you think there are any other factors contributing to the hesitancy in corporate spending, or do you think it’s mostly related to policy uncertainty and the fiscal cliff?
HATZIUS: I think the short-run weakness that we’ve seen over the past few months is related to policy developments. Other than that, if you exclude the last 3-6 months, business investment actually hasn’t performed all that badly in the recovery so far.
I think the growth rates haven’t been spectacular, but you really wouldn’t expect spectacular growth rates given how muted things have been elsewhere, but you’ve seen decent growth rates in business investment. So I think the weakness we’ve seen recently does suggest there’s been a policy impact here.
BI: Back to the balance sheet, multi-sectoral framework of looking at the economy. How did you come to this view? On Wall Street this is still very rare. I don’t see many economists talk about the economy this way, recognizing this identity and making projections based on it. How did you come to see this as the framework by which we should be looking at the economy right now?
HATZIUS: I’ve long been fascinated with looking at private sector financial balances in particular. There was an economics professor at Cambridge University called Wynne Godley who passed away a couple of years ago, who basically used this type of framework to look at business cycles in the U.K. and also in the U.S. for many, many years, so we just started reading some of his material in the late 1990s, and I found it to be a pretty useful way of thinking about the world.
It’s usually not something that gives you the secret sauce at getting it all right, because there are a lot of uncertain inputs that go into this analytical framework, but I do think it’s a reasonable organizing framework for thinking about the short to medium term ups and downs of the business cycle.
Basically, in order to have above-trend growth – a cyclically strong economy – you need to have some sector that wants to reduce its financial surplus or run a larger deficit in order to provide that sort of cyclical boost, most of the time.
There are other factors at play in the business cycle – I’m certainly not claiming that ‘this is it!’ – but I have found it to be pretty useful.
BI: Do you have any explanation or thoughts about why this framework hasn’t broken through more on Wall Street? It still seems pretty rare.
HATZIUS: I’m not sure. I think there are actually a lot of people who think about the world in terms of this chart a little more implicitly. I think if you talk about the need to have stronger demand growth somewhere in order to get acceleration, in those charts it becomes kind of a truism. But if you put it in financial balances terms, you’re not really saying anything dramatically different. It’s just perhaps a little more semantics even. I just find it a reasonable discipline to think about.
BI: Let’s go back to the current state of the economy. One of your colleagues put out a note, sort of keying off your research, saying that real interest rates are finally going to rise and that this could break the back of the gold bull market. What will cause real interest rates to rise? Despite the stronger economy, we still haven’t seen that happen. Long-term and short-term real interest rates have been stuck at incredibly low levels.
HATZIUS: I mean, we don’t have any increase in real rates at the short-end of the yield curve in our forecasts until 2016, those are policy instruments, purely policy instruments, and we would expect the Fed to keep the funds rate at zero even beyond the current 2015 guidance, so we’ve got them hiking sometime after that, in 2016.
At the longer end, nominal rates or real rates are partially policy instruments these days, but they’re partially also responses to changes in the economy and changes in expectations of future short rates, so as you approach the period when you have more lift-off, you would expect some upward pressure on long-term yields relative to the extremely low levels that we‘re at, at the moment.
In 2013, our expectation is that on average, growth is still going to be pretty slow – 2 percent annual average, roughly – but in the second half of the year and in 2014 things get a bit better. And if it’s true that the degree of fiscal drag diminishes and the private sector boost stays with us, I think you can ultimately expect a little bit of upward pressure on long-term yields.
But we still have long-term yields in nominal terms – pretty close to 2 percent by the end of 2013. In subsequent years, I would expect a little more upward pressure if the lift-off date for the funds rate stays in 2015 and doesn’t get pushed through due to additional bad news about the economy.
End of Part 1
