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Five years after the crisis, how healthy is the economy?

October 04, 2013

Five years after the global financial crisis, is the economy finally poised for stronger growth? Vanguard recently put the question to two expert analysts: Mark Zandi, chief economist at Moody's Analytics in West Chester, Pa., and Joe Davis, Vanguard's chief economist and head of the company's Investment Strategy Group.

Mr. Zandi has written several books, including "Paying the Price: Ending the Great Recession" and "Beginning a New American Century." Mr. Davis has published various studies in leading academic journals and is an important contributor to an annual publication, Vanguard's economic and investment outlook.

What are the biggest risks to the ongoing recovery?

Joe Davis: As was the case at the start of the year, the U.S. economy continues to expand at a modest and uneven pace. At present, risks to the recovery exist both domestically and abroad.

Joe DavisUntil recently, the largest threat to the global recovery was Europe. Importantly, we've seen some tentative positive signs out of Europe as those economies begin to stabilize. Nevertheless, there are structural and fiscal imbalances in the periphery that haven't been completely addressed, so European-related volatility could stunt the recovery.

China's economy has also slowed, although incoming data suggest that fears of a Chinese economic "hard landing" may be misplaced. Still, China is unlikely to grow at the double-digit pace of several years ago.

As for the U.S. economy, our belief has been that as long as it's growing, it can weather the expectations of softness throughout most of the rest of the developed- and emerging-market world. But even the largest economy is not immune to weaker-than-expected conditions. At home, uncertainty with respect to our fiscal imbalances and the Federal Reserve's eventual exit from quantitative easing may also be stunting growth at the margin.

The most likely outcome remains that the U.S. economy over the coming quarters grows roughly at a 2% to 2.5% pace. At some point, the outlook will improve and stronger growth will be more likely. Our internal leading indicators are close to that threshold, but they are not quite there yet.

Mark Zandi: I think there was an existential threat to the euro a year or two ago, and that is no longer the case, given the actions by the European Central Bank and the increasing commitment by Germany to keeping the Eurozone together.

Mark ZandiSo I'm much less nervous that Europe will be an issue for us. I'm not expecting much out of Europe for a long time to come, given the structural issues you alluded to. But I do expect them to avoid a crack-up. In fact, I'm hoping for a little bit of growth over the next two, three years, which is a nice change from where we've been.

In the emerging world, China is obviously the key. I think China's economy will have some big zigs and zags in the future—I just don't think that's going to happen in the next two or three years. They've got tremendous resources, including $3 trillion plus in reserves. And they're willing and able to use that pretty quickly if they stumble to any significant degree. So I think China will find its footing, and I expect better conditions over the next one to three years.

When will the United States get back to so-called full employment?

Joe Davis: What constitutes full employment in the economy varies through time. I think the Federal Reserve believes it's when unemployment is around 5.5%. But in my view there is a structural component currently to the unemployment rate, and full employment, at least right now, would mean a rate somewhat higher, perhaps 6.5%. We're not there yet, which is why we have very little wage inflation, around 1.5% to 2%. So I think it'll be some time before we get down to the 6.5% that the Fed has set as its target before raising short-term rates.

If even a fraction of those who dropped out of the labor force return, then it could take until 2016 or 2017 before we reach so-called full employment. Adjusting for those Americans who have dropped out of the labor force because they're discouraged about job prospects paints a rather sobering picture of a labor market more than four years removed from the recession.

Mark Zandi: I think full employment is somewhere between 5.5% and 6%. I do think there's probably a bit more slack in the labor market than the 7.3% unemployment rate would suggest. My sense is that, after accounting for those workers who have stepped out of the labor force and aren't counted as unemployed but say they want to work, there is slack equal to 2.5% of the labor force. For these disenfranchised potential workers to come back into the labor market would require wages to increase more quickly so that they can pay for commuting and child care. That won't happen for a year or two, until unemployment is a bit lower.

Given all this, it will probably take until the end of 2016, maybe into early 2017, to absorb all that slack and return to full employment. So we're a good solid three-plus years away from full employment, which is still a long way to go.

What about housing? Is its recovery finally here to stay?

Mark Zandi: Well, I'm counting on the housing recovery. If we don't get continued gains in construction and house prices, then my optimism around the economy—getting back to full employment in three to three-and-a-half years—that's not going to happen. So the housing recovery is vital to all of this.

I'll just give you one set of numbers to strike the point home and show why I feel relatively convinced that the housing recovery will continue. Current construction, including single homes, multifamily starts, and manufactured housing, is running around 950,000 units annually. In a normal economy, we need to produce something like 1.7 million units per year. So we're well below where we need to be. I'm anticipating a pickup in construction that will get us closer to the larger number, and that it will occur over the next three-plus years. It should provide a significant amount of juice to economic growth and particularly to jobs.

Joe Davis: I would share your optimism on housing, Mark. I think home construction or the broader construction industry could potentially be one of the fastest-growing segments of the U.S. economy over the next three years. But the recovery is not immune to affordability and rising mortgage rates. If there's a risk, it would be that 30-year mortgage rates would somehow approach and then meaningfully exceed 5%. Two or three years from now, if our collective outlook and the Federal Reserve's outlook are correct, then, yes, the housing market could weather rates of 5% or higher, because the other fundamentals would be even stronger.

What have policy makers and investors learned since the crisis?

Mark Zandi: I think the Federal Reserve learned that they can't ignore potential excesses in the financial markets. I think there's now a general sense that policymakers at the Fed and throughout the government need to really focus on looking for excesses in the financial system and then addressing them, if not through monetary policy, certainly through regulatory policies.

Joe Davis: We clearly witnessed a profoundly negative economic and investment event. Many questioned whether the financial markets were still a place to invest for retirement and long-term goals.

But although the past five or six years have been a very volatile period, investors have seen a reaffirmation of long-term investment principles—namely, focusing on cost, balance, diversification, and a long-term orientation. For example, a balanced portfolio of 60% stocks and 40% bonds is now significantly above where it was before the crisis began. Investors who stayed the course should be patted on the back. They were rewarded for staying invested in the markets. While it exposed them to volatility, it's that volatility that was ultimately rewarded by higher returns.

So while it's been a very traumatic period, it's also been one that I think has underscored the value of the timeless investment principles that many investors—whether they're at Vanguard or at other organizations—hold dear.

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