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April 30, 2022 - Epoch Times
35:15
How the Foreseeable Recession Will Impact California | Dr. Jim Doti
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While the inflation rate is extremely high, a number of economists believe recession is around the corner.
To get rid of the kind of inflation we're experiencing now, you have to reduce demand enough to bring inflation under control.
But reducing demand means you're reducing GDP, real gross domestic product.
That's a recession.
My guest today is Dr.
Jim Doughty, President Emeritus at Chapman University and Professor of Economics.
Today he'll discuss why he's predicting a recession and what that would mean for Californians.
The fact that inflation is higher than it's ever been since the 1970s, and arguably the highest it's been since the end of World War II, would suggest that this will be a serious recession.
I'm Siamai Korami.
Welcome to California Insider.
Thank you.
Great to be on the show again.
Yeah, last time we talked to you, you actually predicted that we're going to have a very strong economy.
And I was sitting in this chair, I couldn't believe you, you know, and then our audience was skeptical that this is not going to happen.
But you were right.
Well, that's good to hear.
I'm glad I'm right sometimes.
And it was very interesting because not many people predicted that the economy will do well right after the pandemic.
Yes.
And you had seen the data and the stats, things that the government was doing.
In fact, in many ways, they did too well, too quickly.
And that's what led to the inflation we're experiencing now.
That wasn't a difficult forecast to make.
Knowing at the time when we had the show, I knew...
That the Federal Reserve Board was increasing the money supply to 25%.
It's an unheard of rate.
And that the federal government was spending a deficit of $3.5 trillion each year.
With that kind of fiscal expansion and that monetary expansion, it was easy to forecast not only a strong economy, but down the road inflationary pressure.
Now you're predicting a recession ahead, and we want to talk to you about how this recession would impact California.
First of all, I got worried.
I heard you're predicting a recession.
Tell us why you're predicting a recession.
Well, let me say, we're not quite ready yet at our Center for Economic Research to forecast the timing of recession.
We believe that there will be a recession in the next year or two, but hopefully in the future we'll be able to be a bit more precise.
Are we talking about the end of this year, early next year, late next year?
But the reason we are confident that a recession is going to take place is that the Federal Reserve Board is contracting the money supply.
They're doing a number of things.
Increasing interest rates, and we believe it will not be long before It begins using open market operations, namely selling bonds in the open market, both government bonds and mortgage bank securities.
We have never had a time over the last 50 years where the Federal Reserve Board has started contracting, using contractionary monetary policy to fight an inflation.
It's always led to a recession.
They've never orchestrated what economists call a soft landing, where they're able to get rid of the inflation without leading to a recession.
That's never happened.
It has always led to a recession.
And how do you think this recession would impact us?
We'll get back to discussing this.
I have many questions from you on that.
But how do you think this recession will impact California?
Well, I think it will have a more negative impact on California for a number of reasons.
One, for example, is what's going to happen to housing prices.
With mortgage rates now double what they were about a year ago, they're now at around 5%, that has a significant impact on Monthly payments, principal and interest.
Interest being a major part of a family's payment in their P&I. So one thing that's going to happen is housing prices will begin to decline.
Our forecast calls for a decline in housing prices in the third quarter, fourth quarter about 10%, third quarter maybe 5%, and probably even more depreciation next year.
That's going to have a much more dramatic impact in California because our housing prices are higher.
Not only are they higher, but when they are higher, the degree of drop or decline is greater whenever housing prices in an area are higher.
So, for example, the last time home prices declined in 2008, in 2009, in 2010, During the Great Recession, housing prices dropped in California about 35%, whereas in the nation it may have been a 20% decline because there was a higher base to drop from.
So when home prices are increasing, California home prices increase even faster.
But on the downside, when they're declining, they decline faster as well.
That's one area.
The other is that California income, a larger proportion of it than other states, is in capital gains income.
Those are profits from equities and selling real estate.
And given the fact that There will be this adjustment in equity prices, lower home prices, and lower equity values as well.
There won't be as much in the way of capital gains income.
People won't be making the profits they've been making.
And California intends to make more in profits because there's more wealth.
That wealth is in both housing and in housing.
In the stock market, in 401ks, and given that greater wealth, when there's an adjustment in those asset values, it will hit California harder.
So you mentioned the Federal Reserve, they haven't had a soft landing, and they're trying to slow down the economy.
To bring down inflation.
To bring down inflation.
Do you think they know that they're going to drive the economy into a recession, or do you think they're hoping for a soft landing?
They are hoping for a soft landing, but it's never happened.
There's been this hope before, this expectation that we'll be able to squeeze inflation without leading to a recession.
And here's the reason why They've always failed.
It's not because there are ignorant people on the Federal Reserve Board or that Jerry Powell doesn't know what he's doing.
They're very sharp, intelligent people.
They know about finance.
Many of them are trained economists.
The reason for it is that when you have an inflation, depending upon how you measure it, right now five to eight percent, depending upon the measure, when inflation is that high, In order to get it under control, the only thing that will reduce inflationary pressure is to reduce demand.
In other words, consumer demand has to drop.
That's what the Federal Reserve Board is doing, is tightening up on the money supply to reduce demand.
But to get rid of the kind of inflation we're experiencing now, you have to reduce demand enough to bring inflation under control.
But reducing demand means you're reducing GDP, real gross domestic product.
That's a recession.
You know, if you were to ask me what's the definition of a recession, generally it's two back-to-back quarters of declining real gross domestic product.
SEMA, real gross domestic product, I know it's a complicated sounding term, but what it basically is, is consumer spending, Plus investor spending, plus government spending, plus exports minus imports.
It's an aggregate total of spending.
I guess it's synonymous to someone's health.
What's the best measure of health?
Probably blood pressure.
It's a comprehensive measure of spending.
So to reduce inflation, we have to bring spending down.
But if bringing spending now means that real GDP will be declining, and that's probably what's going to be necessary to get inflation under control, that's a recession.
So tell us more about what you see in this recession.
Is it going to be a harsh one?
Also, at the same time, we have these great resignations and there's not enough people in the workforce.
Some people are wondering, where are these people?
Did they retire?
Are they going to come back?
Do they get some money and they're Having a vacation right now?
What are your thoughts on all this?
That's an excellent question because there are countervailing factors that are weighing into that question.
Number one, the fact that inflation is Higher than it's ever been since the 1970s, and arguably the highest it's been since the end of World War II, would suggest that this will be a serious recession.
Not as serious as the Great Recession recently of 2007, 8 and 9.
And the reason for that is back in 2007, 8 and 9, there was a huge drop in home prices.
The housing market is not as vulnerable as it was back then.
At that point, the drop in home prices put many, many people who had mortgages underwater, where their mortgage was higher than the value of their home.
Well, if you owe more than what you own as an asset, what might you do?
Let the home go.
And it goes into a foreclosure.
So banks, mortgage companies who had these mortgages, all of a sudden they were dumped with homes that they had to sell, which they did.
And when you had this huge supply of foreclosed homes on the market, it brought home prices down significantly.
People lost tremendous amounts of wealth back then.
This time around, although we have a very serious inflation to deal with, much more serious than anything we had back in 2007, 8 and 9, we don't have the overvaluation of home prices that we did then.
So some things will make the recession worse.
Others will make it better.
Another significant problem this time that we didn't have then is while home valuations are not out of whack like they were back then, way overpriced.
This time around, something we didn't have back then was much greater corporate debt.
So when a recession hits, many corporations that are Have issued what is called junk bonds.
The market for those bonds has been very strong because interest rates have been so low that many investors are chasing yield.
They're investing in anything where they could get more than 1% or 2%.
What is that?
Maybe junk bonds that are paying 5%, 6% on that corporate debt.
Or private equity, too.
It's fueled a lot of the debt on the part of companies.
With interest rates increasing, it's going to be increasingly difficult for corporations to roll over that debt.
So a corporation that may have issued a junk bond Let's say at 5%, 5%.
Now, 5, 10 years later, when they have to pay that debt back and roll it over, namely go out, get new debt to replace the old debt, that new debt might cost 10% instead of 5%.
Double!
So, a company that has a significant proportion of its assets in the balance sheet, in the liability side, all of a sudden, those interest payments are going to double.
Sometimes they might be more than what they make, right?
Exactly.
And they may go upside down.
Many companies now are paying much more in interest than they are in profits.
But what this would do is not only erode What can be paid out in profits, it could easily turn profits into a loss.
So that's what would lead to a major correction in the stock market.
And more importantly for the listeners of this show, those people who are working for those companies, there'll be a higher likelihood of layoffs and job terminations.
And the people out of work and the unemployment rate, which now in the U.S. is around 3.5%, can easily go back up to 10%.
Do you have any thoughts on what happened?
How did we get to this unemployment of 3.5%?
It's kind of shocking.
We had the pandemic.
There's a lot of places that are not doing well, but it feels like some people left the workforce.
Yeah.
During the pandemic, when it first hit, and it had a devastating impact in leisure, hospitality, many other businesses as well, but particularly leisure and hospitality, which had a more negative impact in California because we have more jobs in that sector.
We had unemployment hit 20 percent.
During the worst of it.
Now, California is down to about 7% unemployment.
That's double the national rate of 3.5%.
So we have much more unemployment in California than we do with the U.S. But the question, how do we go from 15-20% down to 7% in California, 3.5%, which is as low as it can just about get in terms of unemployment.
How did we recover so quickly?
It's because we used the most aggressive Fiscal policy, namely spending more on the government side than taking in a taxation, and the most aggressive monetary policy, which I referred to earlier when I mentioned that the money supply had increased 25%.
With that kind of Additional demand, it caused a major upswing in spending.
And you had a situation where much of the COVID stimuli, those very, and I use plural, stimuli, because there were a number of different kinds of legislation on the COVID side, many of them related to subsidizing states to pay unemployment compensation for a longer period of time.
Outright checks that were sent out to households.
And this led to a situation where many people were making more money collecting unemployment compensation than they were when they had jobs.
So it led to a situation where they're going to stay home And collect all of this until that runs out.
And it's running out now.
But many people along the way have added to their savings as a result of this infusion of checks and unemployment compensation.
The savings rate increased.
It's highest rate over the last 50 years.
So there's a lot of what economists call dry powder.
They could continue spending, not necessarily have to go back and get their job, be more picky about the kind of jobs they're going to take, simply because they don't have the financial incentives that they used to, to get Before we continue, we would like to thank Shen Yun for supporting this channel.
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Now we will continue the interview.
Now, do you think this hurts us in the long run?
I don't know if this is going to create a culture for people and work.
The relationship between people and work, do you think this is going to have a long-term impact for us?
It depends what you define long-term.
I don't think it's going to be something that we'll have to live with for the next five, ten years, but I think it's going to take several years.
Before we can absorb, before we can reach a situation where many people who are out there, they're not even in that 3.5% figure.
That's what I'm thinking.
If they're out there and they've been out there so long, over six months, they're not even included in the unemployment rolls.
So the question is, how are you going to get those workers back and how long is it going to take?
I don't think it's going to take 5 to 10 years, but I think it's going to take several years before, Before their savings run out and before the economic means or the incentive is great enough for them to go back and rejoin the workforce.
You mentioned the inflation and we're hearing, we're seeing the numbers.
The numbers we're seeing is a lot higher than 8.5%.
Yeah.
What is going to happen to inflation when this slowdown happens?
Because a lot of people are, some people are worried they're buying like assets and Well, the whole point of now moving from an aggressive monetary policy and an aggressive fiscal policy, both are becoming quite contractionary.
We're going, on the fiscal side, we're going from a $3 trillion or $3.5 trillion deficit to a $1 trillion deficit.
That means there is a reduction of $2 trillion in government spending.
That's number one.
Number two, the Federal Reserve Board is increasing interest rates.
So you have, you know, a sharp increase in both short-term rates, like the prime rate, like the 90-day Treasury bill.
But the 10-year bond has gone from 1%, most recently 2.8%.
So it's more than doubled.
All of this will reduce demand.
That will lead to a recession or a serious downturn and that will bring down Prices.
So the inflation we have today, if you measure it by the PCE, it's called the Personal Consumption Expenditures Index, that's what the Fed likes to look at, because it's less volatile, doesn't move around as much, and mainly because it undercounts food and other items that are highly erratic.
But that's around 5%, 5.5% most recently.
If you look at the CPI, it's about 8%.
I think both really undercount the real inflation that's going out there.
For example, one of the things you look at in the CPI is the cost of rent.
That's increased sharply just over the last couple of months.
That hasn't even been included yet.
So I wouldn't be at all surprised to see the CPI going up to 10.
Even the PCE that's now at 5.5 going up to maybe 7.
But by then, when it reaches that point, I believe...
The long-term effects of a tighter money supply and a tighter fiscal policy, what I referred to before.
The 3 trillion, the 1 trillion, the higher interest rates, that will bite into demand.
There'll be a recession, and that reduces Demand for goods and services.
So now, you have this imbalance.
Demand is up here.
The supply of goods is here.
To make that work, when demand is greater than supply, prices have to go up.
But now, with lower government spending as a result of a smaller deficit, higher interest rates, demand's going to drop, but then supply will slowly increase.
And then you'll get a rebalancing so that the pressure On goods and prices will be reduced.
So these supply chain problems and exacerbating the whole thing, of course, is the Russian-Ukrainian war that's going on, also disrupting supply energy and oil prices.
Those things are also worsening the inflationary impact.
Maybe a year from now, hopefully the war is over, some of the supply chain problems will go away, demand will be lower, and we'll see a drop in inflation.
And now, what do you recommend to average viewers that maybe they have some assets or they want to buy a home and also their job?
How could they navigate through this?
Yeah, it's a tough time for, you know, back in December when we, at our Chapman This is our 43rd annual economic forecast.
I was recommending that even though home prices would be dropping the end of this year, that was our forecast.
Still, we have to wait and see if that's going to happen.
But that was our forecast.
I was still recommending that people go out and buy a home because the mortgage rate was, at the time, was only 2.8%.
Now it's five.
So it's become much less optimal to buy a home now.
But I would still, at this point, still recommend it because I think there's a good chance that mortgage rates might hit 7%.
So if you get a five, that's better than seven.
But now I think increasingly people should look at even the possibility, I haven't said this for a long time, getting variable rate mortgage rather than a fixed rate because It might change, it might go down.
I think over a longer haul, over a five-year period, once inflation comes back down, we could see mortgage rates back down to 4%, 3%.
And if you get a variable rate, those would move down with it.
So I'd be very, very careful on the housing side, but still there's probably an opportune time because I think mortgage rates...
Are even going higher.
The problem is trying to find a home because prices are still increasing very rapidly.
The other thing, I'd be very, very careful about equities at this point.
I would not go out and buy long-term 10-year, 20, 30-year bonds because as interest rates continue to increase, the value of those bonds drop.
So right now, I think People who are thinking about their 401ks.
I'm not a financial expert in terms of being licensed.
I can't give this advice.
But what I'm doing, I can tell you what I'm doing, and that is I'm reducing my 401k, my pension, my exposure to stocks, and I'm reducing the proportion in equities from 100% down to 60.
I may reduce it to 40%.
And what I'm replacing it with, basically cash.
Short-term treasury bills, nothing more than 90 days.
They don't pay a whole lot, maybe one, one and a half percent, but that's a lot better than losing the capital value of your holdings.
And I think there will be increasingly prospects for a stock market correction, a downturn, and that means that if you move into cash or cash equivalents, that when When there is that correction in the stock market and prices drop, one can go back with the cash and repurchase those shares at lower prices.
So essentially you've gained.
You've gained, yeah.
What about the jobs?
How can people know, and some people call these companies zombie companies, where they actually have, like, the debt is so much that they're barely making the interest.
How can people know that they're in one of those companies?
Well, look at their debt structure.
If they're sophisticated enough, if they're a public company, you can see their debt as a proportion of the equity.
If you think about it, I don't want to go get too complicated, but if you think of a corporation, they have a balance sheet.
They have assets, liabilities, and net worth.
But if they have a lot of debt, that reduces the net worth.
And to service that debt, they have to be making enough money to pay that debt.
If there's a recession and their revenues drop, as we just talked earlier, they may not be able to do that.
So how does a person who's working for a company Find out if their company is vulnerable is to look at the debt structure and see what proportion out of overall assets, how much in terms of a company's revenues, how much of that has to go back and be used to fund its debt overload.
Now what about the people that have been out of this cycle of working?
Is this a time for them to get back?
Oh yeah, because the payments are now ended.
The unemployment is going to be...
You know, their unemployment now will run out.
States are not going to just keep increasing the date, well, we're going to give you another six months of unemployment or another year to find a job.
All of that is ending.
With the recession, we have a situation where states are not going to have the financial means to To continue to fund long-term unemployment compensation.
The federal government will not have the money as it reduces its deficit.
It will not have the funds to send to states to subsidize unemployment compensation.
They're not going to be getting COVID checks in the mail anymore.
They may get a gas refund check in California.
That's pennies on the dollar.
So yes, I think that increasingly, there'll be an incentive to meet one's expenses and one's budget, make mortgage payments, rent payments.
Increasingly, one will need to go to get returned to the...
and start looking for a job again.
We're turning to the ranks either of the employed or even the unemployed.
Right now, many of them are nothing.
They're not looking.
Yeah, they're not looking.
So, California, we had a huge surplus last year, and now we may have a time where we might face some challenges.
Now, do you think we were able to spend this money effectively?
Well, no, I don't think so.
By the way, the state surplus goes back to what we discussed before with the fact that California is much more dependent on capital gains.
Not only that, the state of California, not only do more of its citizenry get capital gains because of higher wealth, But the state of California, Sacramento, is much more dependent on capital gains than other states because a greater proportion of the state budget,
the operating budget, is funded with income tax, the state's income tax, which is the second highest in the nation after New Jersey, if you combine all taxes, but much higher, much, much higher in income tax.
And that means that if there's a recession and a stock market correction, those capital gains are going to evaporate.
And that means state revenues will decline significantly.
So this huge multi-billion dollar surplus will go away and could be a deficit.
So then all of a sudden the state will not have the...
Resources to continue paying long-term unemployment benefits and relief checks or whatever, and even state spending will drop as well.
And all of that will lead to a more serious downturn or recession and lower spending in California.
And it's going to be worse in California because there's a higher dependence on That portion of income that's most vulnerable to recession, namely stock market gains, that's where capital gains take place.
Also, are there much more dependency on California's government for a certain number of people in California?
There's a lot of programs that are funded by the government.
Do you think that's going to impact?
Well, it goes back to do I think that the state has used the surplus in a responsible way.
And I mentioned no, because that's not going to be there forever.
So when you have something like $40 billion, it's not the $80 billion, by the way, that's being reported, more like a $40 billion surplus.
But that's not insignificant.
I think most of that should have been used to fund replenishing The various pension programs for state workers, even local workers, because the pension fund is still underfunded.
And that's going to be increasingly difficult to fund if there's a stock market correction because The funds that are being used to pay those pensions, much of it is coming from stock market appreciation, higher stock market, capital gains on the part of those funds that are doing the investing.
So I think those funds will be under increasing pressure once a recession hits.
The returns will decrease as well.
Remember, when these pension funds invest to pay To fund the pension payments to retired state workers.
When those interest rates drop again, that's going to make it more and more difficult for these pension funds to service the debt and the payments that they are currently making.
So does they have to come up with more money or these agencies have to come up with more money?
That's why I'm thinking that $40 billion are a much greater proportion of them.
Should have been allocated to those funds.
Now, do you have any recommendations for the state leaders with what's about to come?
It seems like they haven't really thought about what's coming.
Yeah, yeah.
I really think that the state...
I just wrote an op-ed piece with my colleagues at Chapman University, one from UCI. It was a combined Chapman-UCI project.
And we recommended because of this imbalance and over-dependence on the income tax that California needs to do something structurally so it's not so dependent on the income tax.
More importantly, I think the state needs to do something about its tax structure because more and more people are leaving the state.
The most recent statistics on net balance, when you look at the number of people who migrated to California, Versus those that have moved out, the most recent statistic is 350,000 more people have moved out than moved in.
And for the first time in recent history, over the last 50 years, population has declined in California.
So the state needs to recognize something as, why are these people moving out?
You have high tax, high home prices, but we have found in our research much more important as a factor in businesses leaving, jobs leaving, people leaving, is the fact that overall state and local taxes in California, second highest in the Union, only after New Jersey.
Third is New York State.
So that's a major factor for people.
Yeah, people are moving increasingly to Texas, Utah, Nevada, Washington, Florida.
No income tax.
Now, do you have any other thoughts for our audience?
Thoughts?
Well, keep your powder dry, which means that if a recession is coming, increasingly look towards being liquid, conserve, don't spend as much, and, you know, put money away for a rainy day, because I believe that rainy day is coming.
Dr.
Jim Doty, Professor of Economics and President Emeritus Chapman University, it was great to have you on California Insider.
Always great to have you on the show, Simak.
He has some great questions, very probing, difficult questions, but it's nice to be pressured like that on the show, so thank you.
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