Durham economist says to remain positive

Three weeks ago we talked with Durham economist Don Klepper-Smith who helped calm our fears about the economy. We caught up with him again now that the elections are over and the economy is stabilizing – or is it?

What factors will help the economy the most going forward? I think we need to start living within our means, talking about adequate job creation for the long-term and finding a solid bottom within the local housing market. We also need to understand the two “L’s” that are operating in today’s economy.

What are the two “L’s” of the economy? Liquidity and leverage. Liquidity deals with money being readily available from lending institutions for loans such as car, mortgage and student loans. I think the issue of liquidity is being adequately addressed through the bailout as the U.S. government is now providing financial aid to lending institutions, making sure that sufficient levels of funds are on hand for lending. However, our current problems have less to do with liquidity and more to do with leverage.

Explain leverage. Simply stated, leverage is the process of borrowing money against actual money held or actual assets. The more leverage there is, the more debt there is for every dollar’s worth of hard assets. Today, both consumers and businesses alike are de-leveraging, meaning that they are trying to pay down debt that has accumulated over time. This makes sense when assets, like homes and stocks, have declined in value. This winding down of debt is what de-leveraging is all about. The problem of paying down debt today becomes harder because we have a more risk-averse lending environment, fewer jobs, and generally less income. It is harder to get loans when people are losing jobs because banks become concerned that loans won’t be paid off. Is this a realistic concern? Yes. Having a risk-averse credit environment is a concern, especially with the upcoming holiday shopping season. The good news is interest rates on many types of loans are coming down, which makes them more affordable to consumers. The bailout of many banks and insurance companies addresses the liquidity issue, making sure they have enough capital on hand to function. However, banks are increasingly hesitant to lend during periods of economic weakness. We’re going back to an environment where credit standards are tightening. You can put money in the bank, but that doesn’t mean that banks are eager to lend right now.

Is there still a credit crisis? Yes. The credit crisis will vary on a case to case basis, but it’s clear that lending standards in general have become more stringent. In terms of the bailout, some are still wondering whether or not we needed a bailout. My sense is that anything we can do to free up the credit markets probably helps us in the long run. Why? Credit is the fuel that runs our economic engine, so without it, we’re not really going anywhere. In other words, credit means everything to this economy. So anything that restores confidence to the credit markets also restores confidence to consumers and helps get everything back on the right track.

How do you explain the affect the economy is having on the housing market? People are less likely to buy homes during a recession because jobs are being cut and future income growth is uncertain. Today, we also have people who are retiring and want to move out of their homes but aren’t able to. This is because there is generally less demand for homes during periods of economic uncertainty. When supply overwhelms demand, which is what’s happening, prices slide. Ideally, we want a local housing market where supply and demand find a good balance and prices rise gently, yet remain affordable. Therefore, one thing we really need to see today in order to restore confidence is a bottom in the housing market. In other words, we need to work off the existing inventories, which have started to rise. The number one concern down the road is to see a restoration of consumer, business and investor confidence. When we see a bottom in the housing market as far as prices are concerned, it will help restore confidence in Washington and in our elected officials.

Has consumer confidence changed in the last few weeks? Over the last few weeks, consumer confidence is the lowest it’s been in 41 years of record-keeping. The good news is that oil prices are down, but consumers are still upset about the bailout, I think. The big questions surrounding the bailout are: Will we have to print more money? Will our purchasing power be reduced due to a lower dollar? And will that mean higher inflation and rising budget deficits? Taxpayers are rightfully concerned.

Who is affected by consumer confidence? Primarily retailers. The immediate concern is that consumers are less confident, so it looks like it will be a challenging year for many retailers heading into the holiday season. There is not a lot of excess discretionary income for people to spend, and so every dollar counts! Retailers today need to have the right products at the right price with the right amount of service to get through this year. Many retailers are only marginally profitable right now and may have to lay off workers in the months ahead if this economic weakness continues.

How important is the consumer to the economy? Very important! If you think of Real Gross Domestic Product (the size of an economy adjusted for price changes and inflation) as a pie, it consists of consumer consumption, investment, government spending and net exports. The consumers are the most important piece of the pie because personal consumption is 70 percent of the gross domestic product. In other words, what we buy and spend is 70 percent of the economy. And how people feel about the economy has a direct effect on what gets spent.

What should we look for in the newly elected officials? Leadership and a sense of living within our means. Going forward, I think it's increasingly important to live within our means, and rising federal budget deficits in years to come is a cause for concern. Within Connecticut, Governor Rell has a very clear understanding of living within our means and it’s been a real honor to chair her Council of Economic Advisors.

How about outside of Connecticut? Domestically, with this bailout, I’m concerned about what appears to be a two-tiered system where some people are exposed to risk and some are protected from it. It’s this dichotomy that has me worried about ramifications in the long run. Our federal budget deficit is going to be $800 billion to $1 trillion three to five years from now! At some point we need to live within our means.

How do we live within our means? One way is to start creating incentives for saving. We basically do one of two things with the dollar: spend it or save it. In my opinion, it wouldn’t hurt to raise interest rates just a little in order to boost domestic savings to a reasonable level. The savings rate is the percent of money Americans put aside every month for savings, and it's important for times of economic concern. Traditionally, the rate has been 5 percent but today it is .5 percent – one tenth of the normal level. I think the rates are artificially low and therefore people won’t save because they don’t have incentives to do so. Slightly higher rates will be an incentive to save. It will increase the pool of domestic savings in the long run so we do less borrowing from foreign countries. Otherwise, inflation will be higher and the dollar will be weaker.

Would you describe yourself as an optimist or realist? I'm a data-based realist. I try to understand what's happening in the current economy in order to help my clients make good strategic decisions! Let's face it, there are a lot of issues out there right now. A disconcerting mix of inflation and deflation; some things going up, some going down. And many of these problems I mentioned are interconnected. On top of that, everything is complicated because we’re competing in a global economy so there’s more to consider. The good news is that we will probably start to see early signs of recovery sometime in the second half of 2009. In the meantime, I think it’s important to keep a positive outlook because the next recovery is out there in the not too distant future.