Germany
More Muddling Through?
September 10, 2009

By Elga Bartsch | London

Despite the Bounce-Back, Beware of the Headwinds

Rising hopes of a V-shaped recovery and a consensus view that the general election will bring about a change in government towards a more market-friendly centre-right coalition have pushed survey-based business expectations up.  Investor expectations canvassed by the ZEW are now considerably above their long-term average and company-based expectations for the next six months polled by the Ifo Institute are climbing rapidly towards the long-term average too.  The cyclical DAX is up more than 50% from its March trough and many forecasters, including us, are bringing up near-term estimates.  In the light of these positive factors, it is vital not to lose sight of the challenges that still lie ahead.

Recent regional elections have revealed an unexpectedly weak outcome for the Christian Democrats, who lost their absolute majority in two states, and a surge in voter support for the smaller parties, including the Left Party.  Hence, hopes for a change in government could still be thwarted by a re-run of the Grand Coalition.  In addition, the recession has likely done considerable damage to the economy, much of which still has to show - among other things in the labour market, fiscal balances and bank lending.  Notwithstanding the vigorous initial bounce-back, the recovery eventually will likely be a tepid one, we think.

Four Years into the Grand Coalition...

In politics, four years can be a long time, especially in these turbulent times.  Four years ago, Angela Merkel was hailed by some media as a new Margaret Thatcher in European politics.  Campaigning on a strong pro-market election platform, she and her Christian Democratic Party (CDU/CSU) were seen as bringing political change to Germany.  However, the bold reform platform nearly lost Mrs. Merkel the 2005 election.  Despite having had a comfortable lead in the polls over the then incumbent Gerhard Schroeder (SPD), the election night turned into a cliff-hanger and a razor-thin election outcome eventually resulted in a Grand Coalition between the two largest parties, Merkel's CDU/CSU and the Social Democrats (SPD) - an alliance that worked surprisingly well given that neither of the two parties were too keen on the concept (and still aren't). 

...Our Call of a Reform Standstill Now Seems Too Optimistic

In September 2005, we argued that the electorate had opted for a clear ‘neither nor' as far as reforms were concerned and that political standstill was the most likely outcome (see German Economics - A Clear ‘Neither Nor', September 19, 2005).  With the benefit of hindsight, standstill was probably too optimistic a call because the Grand Coalition reversed some of the hard-fought-for labour market reforms (e.g., by introducing minimum wages in several sectors, extending unemployment benefits for older workers, and bulking up short-shift subsidies sharply).  A hike in the VAT by three percentage points - a move the Social Democrats had initially opposed in their election campaign - slowed the economy down in early 2007.  In exchange, top income taxes were hiked (instead of lowered as the CDU/CSU election platform had envisaged) with the introduction of a so-called ‘Reichensteuer', which introduced a new top income tax bracket at 45% from 42% before.  Corporate tax reform lowered the statutory corporate tax rate from 25 to 15%, limiting the overall tax rate including local trade taxes and the solidarity surcharge to less than 30% of profits in exchange for a widening in the tax base (see German Economics: Cutting Corporate Taxes, July 14, 2006). 

A Notable Shift to the Left in the Whole Political Spectrum

In response to the ambitious labour market reforms pushed through by the Red-Green government under Chancellor Schroeder, the SPD lost a part of its left wing, as disgruntled members joined forces with the former East German communists, PDS, to form a new Left Party.  It is partially in response to the formation of this new party at the left end of the political spectrum that the big mainstream parties - the Christian Democrats and the Social Democrats - started gravitating towards the left in an attempt to limit the fallout from a further fragmentation of the political spectrum.  The financial turmoil has likely reinforced the shift in the political platforms. 

Fragmented Political Spectrum Makes it Difficult to Govern

Despite the concessions of the mainstream parties, the political spectrum in Germany remains more fragmented than ever.  While under the German constitution a 5% hurdle for parliamentary representation keeps out smaller political groupings and parties, the share of votes that pollsters are predicting for the Left Party, the Greens and the Free Democrats (FDP) have never been higher.  As a result, it will be more difficult for one of the larger parties - be it the CDU/CSU or the SPD - to form a government with just one junior partner.  Instead, the unpalatable choice becomes one between another Grand Coalition and a tripartite coalition with two of the smaller parties.  Neither of the two constructs is stable and a second term of the Grand Coalition might not even last a whole parliament, as both parties will want out as another Grand Coalition would weaken their base, boosting smaller parties.

Power Struggles and Crisis Could Change the Perspective

Four years into the forced marriage between CDU/CSU and SPD, the key question is to what extent Chancellor Merkel's policy initiatives were driven by the necessity of keeping the coalition together and to what extent they reveal a change in her own party's political agenda.  An election outcome, which allows Merkel to form a government with the pro-market Free Democrats (FDP), would allow her to revive her radical reform ideas - if she still deems them appropriate.  The experience of handling the deepest recession in post-war history and trying to limit the fallout of the biggest financial turmoil since the Great Depression might have changed her perspective.  In addition, some CDU/CSU state premiers have openly embraced more leftist policies over the last few years.  With some of these state premiers potential rivals for political leadership, Chancellor Merkel probably will want to ensure she does not corner herself with too bold a reform agenda.

A Quick Glimpse at the Election Platforms

In what follows, we provide a brief overview of where the parties stand with respect to the key policy areas and contrast these election platforms against what we deem necessary in terms of reforms and against the restrictions posed by the need to comply with the German constitution, notably on the newly introduced debt-brake, and European legislation in areas such as the competition policy and state subsidies.

Taxation 

Regarding corporate taxes, only two parties have clear proposals in their respective election platforms.  The Free Democrats aim to remove some of the restrictions introduced as part of the 2008 corporate tax reform, notably the new limits introduced to the tax-deductibility of interest payments, carrying losses forward after a takeover and off-shoring, thus reducing the effective corporate tax burden.  The Left Party, by contrast, aims to raise the corporate tax rate from 15% to 25% while also broadening the tax base.   When it comes to income taxes, all parties aim to raise the tax-free income (Left, Greens) or alternatively the tax credit for families (CDU/CSU, SPD, FDP).  In addition, CDU/CSU, SPD and FDP all aim to lower the lowest tax band from the current 14% to 12%, 10% and 10%, respectively. 

Meanwhile, the Social Democrats, the Left Party and the Greens seek to raise the top income tax rate from 42% to 47%, 53% and 45%, respectively.  In addition, both the Left Party and the Greens are aiming to raise wealth and inheritance taxes.  Like the Social Democrats, both also support a (re)introduction of the stamp duty on financial transactions, ideally as a Europe-wide tax.

Our assessment: While the centre-left parties favour tax hikes rather than spending cuts to reduce the budget deficit, a centre-right coalition would need to reduce government spending and rein in the budget deficit before being able to cut taxes.

Social Security (Health, Pension)

Faced with deteriorating demographics, shrinking payrolls and rising outlays for healthcare, pensions and unemployment benefits, all parties seek to restore the financial balance of the social security system somehow.  With respect to healthcare, the Social Democrats, the Left Party and the Greens are in favour of extending the current system covering private sector wage-earners to civil servants and the self-employed (who tend to be privately insured).  In addition to wage income, property and investment income should be subjected to social security contributions.  The FDP, by contrast, is heading down a completely different route, proposing a basic private insurance for all, with subsidies for those who cannot meet the costs and with pre-funding age-related outlays.  The CDU/CSU is essentially aiming to maintain the status quo, having abandoned its more radical reform ideas. 

With respect to pensions, both the CDU/CSU and the FDP are in favour of maintaining the status quo in terms of its funding, while the remaining three parties (SPD, Left and Greens) would favour extending the current system for wage earners to civil servants and the self-employed or even to all adults.  Only the CDU/CSU seems committed to see through the planned gradual increase in the pension age to 67.  The Left Party explicitly wants to reverse the steps already taken to raise the pension age.  In addition, the Left Party proposes to phase out financial incentives for private pension plans.  The FDP has exactly the opposite in mind, proposing to strengthen private pensions (both personal and corporate plans).  In addition, the FDP essentially proposes to do away with the fixed pension age and instead allow individuals to decide when they want to retire based on actuarially fair factors once they have passed their 60th birthday.  The FDP is also in favour of allowing pensioners to earn more additional income without cutting their pension benefits. 

Our assessment: None of the parties presently addresses the fiscal time bomb caused by the combination of a rapidly aging society and generous entitlements to pension benefits, healthcare and long-term care. 

Labour Market

Given that bilateral agreements between trade unions and employers associations regarding pay, working conditions and employment protection are a cornerstone of the German economic model, labour market policy does not feature prominently in election platforms.  With two exceptions: minimum wages and potential deviations from the sector-wide agreements.  While SPD, the Left Party and the Greens in general favour a uniform minimum wage across sectors and regions, they differ with respect to the level at which the minimum wage should be set.  The Left Party wants to go furthest by setting a uniform minimum wage at €10 per hour while the Greens and the Social Democrats are somewhat lower at €7.50 per hour.  The CDU/CSU proposes, and indeed in the current parliament has already supported, sector-specific minimum wages.  The FDP, by contrast, is firmly pitched against minimum wages. 

Next to the minimum wage question, another key feature of the labour market programmes is whether parties are in favour of allowing individual companies and their workers to deviate from the sector-wide agreements or whether they even will make them binding for all companies. Typically, companies that aren't members of an employer association are not bound by the sector-wide agreement.  Here the Left Party wants to force everyone into the straight-jacket of the sector-wide agreement, while the FDP is in favour of allowing companies to negotiate tailor-made deals.  In addition, the Left Party is proposing to reduce working time to 35 hours per week at full pay.  The Greens have some sympathy for the idea of limiting deviations from the sector deals and so does the SPD.

In addition, the Social Democrats plan to create four million new jobs by 2020 as part of their so-called ‘Deutschland Plan'.

Our assessment: In our view, the ability of individual companies and their workers (represented by trade unions) to hammer out tailor-made agreements on work and pay was instrumental in the highly successful corporate restructuring (see German Economics: Macro Reforms Meet Micro Restructuring, August 25, 2005).  It would therefore be important not to turn back the clock on minimum wages, which more than anything are a barrier to new competition, and to allow for more, not less, flexibility in company-specific negotiations.

Environment and Energy

One area that has already attracted investor attention ahead of the election is that of energy policy - notably the phasing-out of nuclear power and the issue of solar-tariffs. All major parties are committed to promote renewable energy; they differ in their degree of ambition ranging from 20% for all energy and 30% for electricity by 2020 in the case of the CDU/CSU, to 50% for electricity by 2020 in the case of the Left Party or even 100% for electricity by 2030 and for all energy by 2040 in case of the Greens.

Parties also differ in their commitment to building new power stations (notably modern coal plants) and to capturing and storing carbon dioxide (CO2), which the CDU, SPD and FPD are in favour of and the Left and the Greens are against.  Major difference also exists with respect to running existing nuclear power stations longer (which is acceptable to the CDU/CSU and the FDP).  While no party in Germany is proposing to build new nuclear power stations, the Left Party would like to close down existing power stations immediately while the SPD and the Greens would stick to the agreed exit strategy. 

All parties are in favour of radical CO2 emission cuts.  The CDU/CSU, the SPD and the Greens aim for at least a 40% reduction by 2020, while the FPD is a bit less ambitious at a 30% cut, and the Left party wants to go further and halve emissions.  CDU/CSU, FDP and the Greens are explicitly supporting carbon trading.  While the CDU/CSU is keen to compensate companies for the costs of carbon trading, the Greens would like to see a phase-out of exceptions for energy-intensive sectors.  When it comes to international carbon offsets, the FDP would like to see more of these being used, while the Greens want to disallow them. 

Most parties have not made clear commitments regarding carbon or energy taxes in their manifestos.  Only the FDP states that it would like to see a cut in the VAT on energy or a cut in explicit energy taxes, while the Greens are clear that they want the exceptions from the energy tax to be abolished and cut back subsidies for activities harming the environment.

Our assessment: While the nuclear question is important for securing long-term energy supply, many of the other issues, notably the commitment to cut emissions or to boost renewable energy sources, are eventually taken at the European or even the global level. 

Fiscal Consolidation

All parties are rather ‘stumm' when it comes to explaining to voters how the ballooning budget deficit is meant to be reduced in the years to come, certainly one of the key challenges facing the incoming government.  Based on the election platforms, it seems that the Left Party would probably be the least committed to fiscal consolidation because it fundamentally favours a bigger government sector and, if anything, would engineer it via higher taxes, notably for companies and higher-income earners.  Meanwhile, the FDP and to a lesser extent the CDU/CSU, which both aim to lower taxes in the next parliament, would probably favour a reduction in government spending in order to create the room for tax cuts.  While SPD's Finance Minister Steinbrueck spoke out in favour of an early start of the fiscal consolidation, it is not clear whether this statement reflects the views of the whole party.

Our assessment: All parties would be under pressure to comply not just with the rules of the Stability and Growth Pact (SGP) but also with newly introduced debt brake laid down in the German Constitution.  The debt brake essentially limits borrowing of the federal government to 0.35% of GDP from 2016 onwards while not allowing regional states to run deficits from 2020.  An only tepid recovery will limit the cyclical improvement in budget balances, we think, and, like many other governments, the next German government is likely to look at various options, including privatisation (see European Economics & Strategy: Poor State of Government Finances & Implications for Equities, September 1, 2009).

At the Moment, the Polls Show a CDU/CSU Lead over the SPD

As a result, it looks likely that the election could indeed bring a change in government towards a centre-right coalition of the CDU/CSU and the FDP.  Based on the colours representing the two parties, such a combination has also been coined a Black-Yellow coalition.  But the relatively narrow lead of the two parties, the surprises in the recent regional elections and the uncertainties created by the German election system suggest that there is a chance of the change in government being thwarted.  While arithmetically, in addition to the Grand Coalition, a number of other combinations would be possible, largely incompatible election platforms make these unlikely at the national level - at least for now.  Only one pollster currently deems a Red-Red-Green coalition between the SPD, the Left Party and the Greens possible. 

The So-Called ‘Chancellor Model'...

As an alternative to the polls, a statistical model can be used to predict the election outcome.  One such model is the so-called Chancellor Model, whose claim to fame is to have predicted the last election outcome correctly with a margin of error of only 0.3 percentage points (see H. Norpoth, T. Geschwend - "The Chancellor Model: Forecasting German Elections", International Journal of Forecasting, forthcoming).  In 2002, the model also did very well when it correctly predicted a return of the Red-Green coalition with its three-month-ahead forecast beating even the exit polls on the night, according to the authors.  For the upcoming election, the model forecasts a coalition between the CDU/CSU and the FDP with a clear majority of 52.9%. 

...Suggests an Even Clearer Outcome than the Polls

The model is based on three factors: 1) the popularity of the incumbent, which in Angela Merkel's case at 71% is very high; 2) the long-term partisanship of the population, which is estimated at 44.1% for CDU/CSU and FDP combined; and 3) voter fatigue with the governing coalition, which tends to rise over time. But given that Angela Merkel has only been in office for four years, voter-fatigue should still be limited.  Two factors introduce potential uncertainties: first, the fact that the parties of the Grand Coalition ideally want to part company after the election poses a predicament for the model, which is set up to predict the likely return of government coalitions.  Second, for the new Left Party, long-term partisanship is still difficult to estimate.  Hence, despite the model's impressive track record, we could still be in for a surprise on the election night.

Additional So-Called Overhang Mandates that Individual Candidates Can Win...

The potential for surprises on the election night is partially due to some procedural rules of the election system, notably the existence of so-called overhang mandates.  These overhang mandates imply that it is not clear a priori how many seats the new parliament will have.  This is because in any general election, German citizens cast two votes.  With the first vote, they choose a candidate in their election district; with the second, they vote simply for a party.  It is the second vote that determines the parties' relative strength in the lower house of parliament, the German Bundestag.  However, if a party manages to win more direct seats than the share in the second vote would suggest, it retains the additional seats as so-called ‘overhang mandates'.  The overhang mandates make it possible that a party can have more seats in parliament than the share in the second vote would suggest. 

...and the 5% Hurdle Can Make Election Outcome Hard to Predict

The second element causing potential surprises is the hurdle for parliamentary representation: only parties that receive at least 5% of the (second) votes or gain at least three direct mandates on the first votes can be represented in parliament.  Hence, votes for small parties that don't make the cut get lost in terms of parliamentary representation.  This is why often less than 50% of votes in the polls are sometimes sufficient to form a coalition.  At the current juncture, none of the three smaller parties that are represented in parliament is estimated to come in anywhere near the 5% hurdle though.  But this has been different in past elections.  With some votes falling out of parliamentary representation due to the 5% hurdle and some extra seats being added due to overhang mandates, sometimes as little as 47% of the national vote has been sufficient to capture the majority of parliamentary seats.

Election Timeline Could Be Upset by Twitter Too

Usually the timeline of events on an election night is very clear.  The polling stations in Germany close at 18.00 local time.  First estimates of the outcome based on exit polls are typically available soon afterwards from all major TV stations.  Within the first 90 minutes, they tend to have a pretty good handle on the election outcome.  The preliminary official result typically is known before midnight.  Ahead of these official results, a big TV debate with the leaders of all major parties takes place starting around 21:00 local time, which gives first insights about potential coalitions to be formed.  However, new means of communication could upset this well-rehearsed routine.  In the recent regional state elections, exit polls were leaked to the public via Twitter, and there are concerns that this might happen again in the general election.  As in many other countries, publishing exit polls while the polling stations are still open is illegal and could potentially trigger a discussion about whether the vote could be void.  Even though legal experts believe that such a leak is unlikely to cause the vote to be void, the discussion would add to the uncertainty.

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United States
US Economic and Interest Rate Forecast: Recovery Arrives - but Not a ‘V'
September 10, 2009

By Richard Berner & David Greenlaw | New York

We continue to believe that a sustainable recovery is underway in the US economy, but it likely will be a bit quicker and even bumpier than we expected a month ago (see It's Bumpy and Slow...but it Will Be a Sustainable Recovery, August 10, 2009).  While we have boosted our 2H09 GDP outlook this month by 0.25% to 3% annualized, we now believe that a 3Q surge (+4.5%) will give way to a more tepid gain in 4Q (+1.5%).  We expected +3.5% and +2%, respectively, last month.  The sharper deceleration in the current forecast reflects somewhat larger ‘paybacks' in vehicle and housing sales.  That slowing may stir ‘double dip' recession fears, especially as the jobless rate heads higher, consumer income remains under pressure and companies continue to focus on cost control.  Yet in our view, the near-term slowing will simply represent a bumpy path to sustainable growth, as is also reflected in our first cut at the outlook for 2011. 

US Forecasts at a Glance

(Year-over-year percent change)	2009E	2010E	2011E
Real GDP	-2.5%	2.7%	2.8%
Inflation (CPI)	-0.4	2.1	2.5
Core Inflation (CPI)	1.6	1.4	2.0
Unit Labor Costs	-1.4	-0.5	1.1
After-Tax "Economic" Profits	-10.5	12.6	8.7
After-Tax "Book" Profits	-9.8	12.8	8.1

Source: Morgan Stanley Research    E= Morgan Stanley Research Estimates

 

Two Key Elements in the Case for Sustainable Growth

The case for sustainable growth isn't open and shut.  But it rests on two key, near-term developments: First, credit is becoming cheaper and somewhat more available as markets heal and lenders return to profitability.  While spreads on risky assets remain wider than two years ago, they are significantly narrower than they were at the height of the crunch.  30-year mortgage rates are hovering just over 5%, or more than 100bp lower than last fall, and spreads to Treasuries have returned to historical norms of 160-170bp.  The Fed's credit and liquidity programs and those of other central banks have significantly improved the functioning of and liquidity in funding markets, so that the absolute levels of interbank lending rates stand at record lows and spreads over overnight index swaps (OIS) are nearly back to pre-crisis levels.  Correspondingly, although lenders are still cautious, the terms on which they are extending credit and making it available are both easing.  Captive finance companies at vehicle OEMs have reduced required down-payments, and borrowing rates on new car loans have slipped below 4%.  And while credit spreads have been locked in a range over the past month, the lagged impact of the narrowing that occurred previously is only now starting to help refinancing and economic activity.

Second, and in contrast to worries that the effects of fiscal stimulus will soon peter out, we believe that there are significant lags between fiscal thrust and fiscal impact, with the latter providing ongoing support for growth.  Some background on this point might be helpful.  The term fiscal stimulus generally refers to a budgetary change that is measured relative to a standard baseline.  In other words, the dollar amount of tax cuts or spending increases compared to what would otherwise have occurred in the absence of any policy change.  In the US, policymakers have arbitrarily decided to use a 10-year window to measure the amount of stimulus associated with any policy proposal.  So, the US$787 billion of stimulus associated with the American Recovery and Reinvestment Act of 2009 (ARRA) that was adopted back in February reflects the cumulative budgetary impact, through FY 2019, relative to the CBO baseline.  Such a measure of ‘stimulus' can be misleading for several reasons.  First, the current law baseline is not necessarily the appropriate starting point from which to measure the amount of policy stimulus.  For example, the US$787 billion estimate includes US$83 billion in FY 2010 for an alternative minimum tax fix.  But this clearly does not represent any net new stimulus because the exact same AMT relief has been adopted every year for quite some time.  The US$83 billion is merely an adjustment to account for a distorted baseline.  Moreover, ARRA did not address the scheduled expiration of the 2001 and 2003 tax cuts at the end of next year. This will lead to a significant tightening of US fiscal policy in 2011.

A more meaningful measure of fiscal policy involves the cyclically adjusted or standardized budget concepts.  These measures filter out the impact of cyclical and other special temporary factors on the budget (see "The Cyclically Adjusted and Standardized Budget Measures", CBO, October 2008, for more details on how these series are derived).  Changes in these measures of the budget are generally considered to be a good gauge of ‘fiscal thrust' - the influence of the budget on overall aggregate demand.  But there can be lags between the budgetary impact of a policy change and the associated influence on aggregate demand.  In this particular instance, we believe that such lags are significant.

Measured by the change in the cyclically adjusted federal deficit in relation to potential GDP, fiscal thrust should fall to about zero by the middle of 2010, and if the Bush tax cuts sunset as scheduled on December 31, thrust could turn into significant fiscal drag.  But because we suspect that there are lags of anywhere from 3-9 months between thrust and impact - especially for infrastructure outlays which seem only now to be improving - we believe that the fiscal impact will remain positive well into 2011.  Indeed, we have long argued that the credit crunch and consumer wealth losses would reduce the so-called multiplier effects of fiscal stimulus, at least through much of 2009 (see Policy Traction: The Key to Recovery, February 17, 2009).  The jury is still out, but it appears that such multipliers may well improve later this year and into early 2010.  And of course, there is a third element: Both forms of stimulus buy time for the healing in financial markets to continue, for companies to liquidate inventories until they are lean, and for the building of some pent-up demand for durables that typically boosts spending following a long period of retrenchment. 

One additional part of the stimulus story deserves mention.  As many analysts have observed, at least a portion of the stimulus coming from the federal government is being offset by spending cuts and tax increases at the state and local level.  This is no doubt true today, but keep in mind that such offsets always occur at this stage of the economic cycle.  This reflects the fact that almost all state governments and local jurisdictions are prohibited from running a budget deficit.  When the economy slows, their finances always come under pressure and they respond with standard pro-cyclical measures.  The more severe the economic slowdown, the more severe the budgetary pressures.  What differs from cycle to cycle is the magnitude of the federal response.  In fact, federal grants to state and local governments to help fund Medicaid outlays have been a major cushion for the state and local budget crunch.  So, we should not get too hung up on any state and local offset - it is hardly a unique feature of this cycle. 

Ending Incentive Programs May Trigger Paybacks

Two (and perhaps three) elements of fiscal stimulus do appear to have gotten traction with significant bang for the buck: The ‘cash-for-clunkers' program and the first-time homebuyer tax credit incentives have boosted demand for vehicles and homes.  In addition, bonus depreciation investment incentives may be boosting business investment.  But because of their ‘use-it-or-lose-it' nature, these programs all boosted purchases while in effect, but ending them may trigger near-term ‘paybacks' for demand that was brought forward.  Just how big those paybacks are is uncertain, but past experience suggests that they may be significant and last for a few months.  

The ‘cash-for-clunkers' (C4C) program is probably the clearest example of an incentive that temporarily boosted today's demand at the expense of tomorrow's.  The auto scrappage program provided either a US$3,500 or US$4,500 credit towards the purchase of a new, more fuel-efficient car or truck when old, gas-guzzling clunkers were traded in.  Congress initially funded the program at US$1 billion, but quickly expanded it to US$3 billion, and funding ran out exactly a month after being put into effect.  The Department of Transportation estimates that 690,114 vehicles, primarily cars, were sold under the program at a cost to the taxpayer of US$2.877 billion, so it clearly was a huge success in attracting buyers.

Industry anecdotes suggest that roughly a third to a half of the purchases were simply brought forward into July and August at the expense of September and October.  Past experience with sizeable incentives for vehicle purchases - for example, the post 9/11, zero interest rate ‘Keep America Rolling' financing program on all GM models that lasted for five weeks - also suggests that the surge in demand may be short-lived when the incentives expire.  Sales jumped 35% in September 2001 to a record 21.7 million, but were already fading fast by late October.  When Hurricane Katrina ‘scrapped' thousands of vehicles in 2005, insurance payments fueled a 15% sales surge, which gave way to a payback in subsequent months.  However, even though a portion of the recent sales surge is borrowed from future months, signs of healing in the broader economy mean that demand should still hold above the 9.5 million annualized pace seen during the first half of the year.  We assume that sales will slip from August's 14.1 million rate to roughly 10 million in September/October and then gradually improve.

Answering the same questions about the first-time homebuyer tax credit is more difficult because the program lasted longer, the incentive represents only about 5% of the price of homes typically purchased by first-time homebuyers (versus 16% for C4C), and because there is scant basis for comparison - there is only one example of a similar credit (in 1975, and that one was for new homes only).  This time round, lawmakers enacted two credits for first-time homebuyers.  A US$7,500 credit launched in July 2008 was really an interest-free loan.  Then, in February 2009, Congress replaced it with a true credit running up to US$8,000 for low-income buyers who had not owned a residence in the last three years, expiring on December 1, for both new and existing properties. 

The new credit probably stimulated demand, but it is unclear by how much.  According to the National Association of Realtors (NAR), about 350,000 of the 1.8-2.0 million buyers who will claim the credit this year would not have purchased a home without it.  But it is uncertain how much of that is genuine additional demand and how much was simply brought forward.  Traditional measures of affordability have soared, courtesy of the plunge in home prices and in mortgage rates.  But with lenders demanding bigger down-payments and with the credit not available until the deal is closed, down-payments and credit availability remain hurdles for many buyers, especially first-time ones. 

The 1975 homebuyer credit represents the sole historical parallel and may shed light on the potential payback this time.  That earlier incentive, which was aimed only at new homes, initially boosted sales and triggered a second surge as the expiration date neared.  Fueled by lower mortgage rates, pent-up demand and the credit, new home sales jumped by 63% over 1975, but declined by 16% over several months in 1976 after the credit expired.  That moderate ‘payback' may foreshadow today's experience, as home-ownership rates today for those up to 35 years of age are back down to 1999 levels, indicating a modest improvement in pent-up demand.  Also, earlier this year, the state of California adopted a US$10,000 tax credit (to be applied over the course of three years) for purchase of newly constructed residences.  The program got up and running in March, and the US$100 million of authorized funding was exhausted as of August 31.  About 10,000 buyers took advantage of the program over this six-month interval, and we think the program was probably too small to generate any payback effects.  Total home sales in California during 2009 should be somewhere in the neighborhood of 550,000 - so the program was used for only about 2% of this year's sales.  The bottom line is that we assume both home sales and single-family housing starts will soften a bit early next year and rise moderately thereafter.  One caveat - the industry is pushing hard for an extension of the homebuyer credit, and numerous pieces of such legislation have been introduced in Congress.  If passed, an extension would certainly boost our near-term outlook, but our Washington contacts believe that the prospects are relatively low at this point.

The third temporary incentive - ‘bonus depreciation', or temporary partial expensing of capital investment of 50% for corporate investment in assets with tax service lives of 20 years or less - will expire at the end of this year.  We do not believe that this incentive significantly boosted capex, especially for those companies that had no tax liability this year or in the immediate future.  So, any payback from the sunset of this incentive probably will also be minimal.

Aggressive Payroll Cuts Make a Jobless Recovery Less Likely

Fears of a ‘jobless recovery' are rising, following relentless declines in payrolls and increased unemployment.  In turn, limited or no job gains would stifle recovery in spendable income and consumer outlays, further suppressing what we see as a moderate recovery.  Businesses aren't likely to hire until they are confident in recovery, and with the workweek low, businesses likely will expand hours for existing workers before hiring new ones.  However, we believe that a jobless recovery is less likely than in the past two recoveries, partly because past job cuts have virtually eliminated what were minimal hiring excesses.

One way to measure the extent of hiring excess or shortfall involves cumulating the errors made by a relatively standard relationship used to forecast labor hours worked (and, with a projection for the average workweek, employment).  The explanatory variables include the outlook for output, factors that affect productivity such as the services from capital, and a dynamic adjustment process that captures the typical pro-cyclical surge in productivity early in recovery.  If positive, the cumulative differences between actual hours and those predicted by the relationship suggest that there is an overhang of labor to work off.  As it turns out, the errors over the course of the expansion that ended in December 2007 were small, reflecting business caution about hiring.  And through 2Q09, the errors cumulate to zero, suggesting that the aggressive job cuts seen in this recession have eliminated any excess.  Although we expect employment to begin growing by the end of this year, declines over the July-December period will push those cumulative errors sharply negative, implying some underlying pent-up demand for labor that should materialize at some point down the road. 

Slow Exit from Policy Support Means Sustainable Growth Through 2011

Policymakers will slowly exit from monetary and fiscal stimulus as inflation remains low, markets heal and the cyclical dynamics of recovery take hold.  Officials have signaled those intentions with regularity since meeting at Jackson Hole in late August, in speeches, Op-Ed pieces in the financial press, and at the G20 meetings of central bank chiefs and finance ministers in London this past weekend.  We continue to think that the Fed will taper off its asset purchase programs, wind down its credit and liquidity programs as market conditions permit, and keep rates unchanged until mid-2010.  Such a stance should enhance prospects for sustained growth beyond 2010.  And we believe that the lags in fiscal policy mean that stimulus from the fiscal side will persist through 2011.

However, as we look ahead to 2011 for the first time, we do see a slower expansion.  On a 4Q/4Q basis, we expect GDP growth will moderate from 3.25% in 2010 to around 2.5% (which is in line with our estimate of potential growth), while inflation will move slightly higher in tandem with the trajectory of oil prices.  (Note that on a year-on-year basis, we expect 2011 real GDP to accelerate to 2.8% from 2.7% in 2010; mostly that reflects a hearty end to 2010.)  In our view, several factors will promote a slowing in growth.  Unless policies change, fiscal drag will begin in 2011, with the sunset of the Bush tax cuts (a tax hike of about US$300 billion, or 3% of disposable income) and the waning effects of ARRA.  In addition, a less stimulative monetary policy, higher rates out the curve as private credit demands begin to normalize and (to a modest extent) higher oil prices will promote a deceleration. 

Nonetheless, in 2011 several forces of recovery will still be at work.  Home prices should stabilize or even rise, and financial conditions and credit availability will likely ease a bit further.  Inventory liquidation may shift to accumulation.  Rising operating rates and cash flow may help capital spending.  Those factors probably contribute to the Fed's buoyant forecast for 4.2% (4Q/4Q) growth in 2011.  Despite the expected deceleration and a still-high unemployment rate, we look for the Fed to continue moving policy back towards neutral during 2011.  We currently expect the Fed to raise rates by 150bp in 2H10; a further increase of 100-150bp would get policy a lot closer to neutral by the end of 2011.

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