Economy Q&A: We Answer Your Questions

by the Schwab Center for Financial Research
Updated June 19, 2009

Each month, we receive thousands of questions from Schwab clients. Here, we tackle the top questions on the economy, with answers and guidance that we believe will address some of your most pressing concerns.

If you have a question that doesn't appear below, we have more Q&As on timely topics in the box at right. If you have a question that we haven't already addressed, you can submit it using the Editor Feedback form at right—we may include it when we add new questions and answers.

To talk to a Schwab investment professional about your particular circumstances, please call 800-435-4000.

On the economy

NEW:_Is it possible that rather than see depreciation in the housing market inflation we'll be encouraged by the Fed to absorb the disproportionately high home prices?
NEW:_We seem to be in uncharted waters. Can we still rely on standard indicators of a recovery?
NEW:_How is the national debt affecting our economic downturn?
How much of a deficit can the United States run before we have ratings problems or trouble selling U.S. debt?
When did the recession start?
What signs do you look for that an economic recovery is in progress? Or that the recession might turn into a depression?
Why is the dollar so strong when the U.S. Treasury is broke and the deficit is astronomical?
Do you see a possibility for the United States to fall into a period of stagflation like we saw in the late 1970s and early 1980s?
Do you think the current bailouts will create severe inflation in the future? And with commodity prices falling and a worldwide recession under way, what are the chances of deflation?
How will we know when the economy has hit bottom?

Is it possible that rather than see depreciation in the housing market inflation we'll be encouraged by the Fed to absorb the disproportionately high home prices?
The Fed’s massive monetary stimulus has not been done solely to absorb high home prices, nor should that be the goal. Its more valuable goal is to lower private sector borrowing rates, in order to re-stimulate demand for housing. Of course, there exists substantial risk that inflation will increase dramatically down the road, but monetization is more easily reversible than if the government nationalized the mortgage market.

The bottom line, though, is that artificial policies or stimulus created solely to prop up home prices can have many negative consequences. What we really need is for home prices to fall to their natural level of affordability. If the government attempts to artificially boost house prices, the recovery will just take more time.

We need to let supply, demand and price work their typical magic—price decreases will ultimately lead to higher sales. Most of the regional markets where prices have come down more severely have seen the commensurate biggest jumps in sales. Artificially keeping prices high through government intervention, or by unleashing inflation purely to combat falling prices, will also deny affordable housing to future buyers.

High inflation is not the answer—it would hurt individuals who don’t own homes, as they would feel the full impact of inflation without the benefit given to ailing homeowners.

We seem to be in uncharted waters. Can we still rely on standard indicators of a recovery?
Many standard indicators of recovery are still valid. As always, the stock market tends to lead the economy, so it remains one to watch. The historical engines of growth that have pulled the United States out of recessions in the past are unlikely to provide much support this go-round. Household spending, inventory rebuilding, income growth and home construction will likely remain lackluster in 2009. What we’re banking on in this era are unprecedented low-cost borrowing opportunities, and increased government spending.

How is the national debt affecting our economic downturn?
The national (or government) debt—the sum of all annual budget deficits—stands at just under $11 trillion (still under 75% of GDP). To put that in perspective, government debt was almost 130% of GDP following World War II, and Japan's current national debt is about 180% of their GDP.

Still, it's a worrisome trend. Interest payments alone on the national debt will near $500 billion this year, making it the fourth largest federal expenditure, after Medicare/Medicaid, Social Security and defense spending. National debt affects the economy and its participants via higher taxes, reduced government services and the risk of higher inflation. If too much debt is taken on and the capital stock is expanded too fast, it can lengthen and deepen a recession.

It will also force continued federal government borrowing, increasingly from China, Japan, Britain, Saudi Arabia and other foreign creditors. Increasing the national debt removes an equal amount of investment capital from total funds available to lend worldwide.

For now, the combination of domestic and foreign demand for Treasuries is more than sufficient to finance our deficits, but it's a longer-term concern.

How much of a deficit can the United States run before we have ratings problems or trouble selling U.S. debt?
The United States currently carries a bond rating of AAA from Standard & Poor's, as do 18 other countries. S&P's current outlook for the United States' AAA rating is "stable." In fact, since bond ratings have existed, the United States' rating has rarely been in doubt—and it doesn't seem to be in doubt now.

Let's look at some numbers: In 2008, the U.S. budget deficit—the amount by which the federal government's spending exceeds its income— as a percentage of gross domestic product (GDP) was 4.7%, or $675 billion. That's the highest of any AAA-rated country, plus Japan (currently rated AA).

However, looking at U.S. debt—how much we've borrowed to finance our excess spending—as a percentage of GDP, we're not the highest. The median among AAA-rated countries is 41% of GDP. The United States is at 60%. Three other countries (Austria, Germany and France) are between 62% and 65%.
The numbers for Japan are also worth noting—total gross debt is a whopping 218% of GDP, declining to 82% net of other financial assets (such as cash, deposits and loans). That compares to 56% of GDP net of other assets for the United States. The Japanese federal deficit in 2008 as a percentage of GDP was 3.8%.

To match for the highest debt as a percentage of GDP among AAA-rated countries, the U.S. could add $575 billion in debt on a gross basis, or $883 billion net of other government assets. To reach Japanese levels, we'd have to add almost $23 trillion in debt on a gross basis, or $4 trillion net of other assets.

Of course, none of these metrics would guarantee an actual rating change. But should we care about ratings when it comes to the U.S. government? Let's cut to the main point: Will the United States have trouble borrowing money at a reasonable price?

The fact that the U.S. dollar continues to be the world's pre-eminent currency is the key. If this were to change, it would cost the United States more to borrow from other countries—or put another way, we'd have to pay higher interest rates on U.S Treasuries to attract foreign buyers. The dollar's fate depends quite a bit on how we navigate through the current financial crisis, as well as on the vibrancy of the U.S. economy.

As for liabilities, S&P estimates that the U.S. government's total worst-case exposure to the financial meltdown would be 25% of GDP. That's sizable, but still manageable without increasing our debt to the levels Japan carries. Analysts anticipate that Social Security and Medicare may actually be bigger long-term risks, as well as confidence of the world in the U.S. as a competitive source for stable, long-term investment, in context of our deficits or ultimate debt burden.

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When did the recession start?
The recession began in December 2007, according to the National Bureau of Economic Research (NBER), a private, nonprofit group of university economists charged with making the official determination. Many people assume that a recession is when GDP contracts for two consecutive quarters, but the NBER also considers measures of employment and personal income before officially announcing a recession.

What signs do you look for that an economic recovery may be in progress? Or that the recession might turn into a depression?
To learn more, read David Kastner's article, How Bad Can It Get?

Why is the dollar so strong when the U.S. Treasury is broke and the deficit is astronomical?
Our views on the strength of the dollar change from time to time based on market conditions. See Is the Fed Turning the Dollar Into Monopoly Money? for our most current view.

Do you see a possibility for the United States to fall into a period of stagflation like we saw in the late 1970s and early 1980s?
We don't see stagflation ahead. It's true there was a meaningful and legitimate inflation scare last year, at the same time economic growth was faltering. However, we believe that deflation is the greater risk these days (see the next question).

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Do you think the current bailouts will create severe inflation in the future? And with commodity prices falling and a worldwide recession under way, what are the chances of deflation?
Liquidity is being pumped into the financial system in unprecedented fashion, but these actions are not yet inflationary. True, the size of the monetary base is surging, as is the money supply, but the velocity of money—M2 divided by the monetary base—is plunging. Also known is the "money multiplier," this measure indicates whether the money being pumped into the system is getting through into the broader economy. To date, that's not the case, which is why we see deflation as a greater risk.

For more of our current thinking on the prospects for inflation and deflation, see Arc of a Diver: Inflation Succumbs to Deflation by Liz Ann Sonders.

How will we know when the economy has hit bottom?
There are a number of indicators that provide clues as to when the economy has bottomed and is beginning a recovery. Many can be found in the Leading Index (aka the LEI or Leading Economic Index) compiled each month by The Conference Board.

In addition, the stock market has an excellent track record of signaling a bottom in the economy about six to nine months prior to the actual turn in the economy. But it's hard to identify an enduring trend in stocks as it's happening. For that reason, economists and strategists use leading economic indicators, as well as coincidental and even lagging indicators, to try to confirm what the stock market is telling us.

Among some of the leading indicators with a good record of confirming stock market signals:

Initial weekly jobless claims for unemployment insurance.
M2 money supply growth.
Interest-rate spreads (10-year Treasury bonds minus the federal funds target interest rate).
Average weekly hours worked in the manufacturing sector.

However, given the root causes of the current recession—falling home prices and the turmoil in the financial system—we're also keeping a keen eye on:

Home prices (Case-Shiller 20-City Index).
Commodity prices.
The dollar.
Numerous measures of lending standards (provided by the Federal Reserve).
Liquidity and confidence (LIBOR, corporate borrowing rates over Treasuries, credit default swap spreads).

We cover many of these indicators in the Schwab Market Perspective by Liz Ann Sonders and Brad Sorensen, which we update every two weeks.

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Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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