The end (of recession) is near, but it won't be pretty

An anemic economic recovery will begin at the end of the year, but don't expect the pain to end anytime soon. That was the analysis provided by top economic experts from the W. P. Carey School of Business and the Arizona governor's office at the annual Economic Outlook Luncheon on May 20. Economists Dennis Hoffman and Lee McPheters shared the podium with Eileen Klein, director of the Arizona Governor's Office of Strategic Planning and Budgeting. Their message was that the economy will begin to regain strength, but the process will be slow. Meantime, if nothing is done to address the problem, the state's revenue gap will continue to widen over the next several years.

The national and Arizona economies are expected to begin feeling the effects of a recovery during the last quarter of 2009. But over the next year the recovery will be slow, with unemployment continuing to rise and economic growth anemic at best. Meanwhile, the state's expenditures are rising, even as revenue continues to fall, setting the stage for future budget cuts and an expected tax increase.

That was the consensus unveiled by top economic experts from the W. P. Carey School of Business and the Arizona governor's office at the annual Economic Outlook Luncheon on May 20.

Addressing the audience of business and community leaders were Lee McPheters, director of the JPMorgan Chase Economic Outlook Center at W. P. Carey and editor of Economy@W. P. Carey; Dennis Hoffman, director of the L. William Seidman Research Institute at W. P. Carey; and Eileen Klein, director of the Arizona Governor's Office of Strategic Planning and Budgeting. McPheters provided an overview of current economic conditions on the state and national level, and offered a forecast for the coming year.

The U-shaped recovery

"The economy is going to show some signs of recovery in the last part of 2009, but the way I like to look at this is that lots of our economic indicators will still be underwater, in a sense — they just won't be as far underwater," he said. "We'll probably see positive growth in GDP, we will see job losses getting smaller, but there will still be job losses. There will still be people claiming unemployment insurance and, of course, unemployment rates will still be going up.

"It's going to be a deep, sort of U-shaped recovery and 2011 will probably be a pretty good year of job growth," McPheters added. In the meantime, job losses will continue to mount. In March, with an over-the-year employment decline of 7.1 percent and 136,000 jobs lost, the Valley just edged out Detroit as the weakest large metro labor market in the nation. And even as the economy begins to recover, the Greater Phoenix area will still see its labor market contract by 1 percent in 2010, according to McPheters.

Nationally, McPheters stressed that while the current recession has been painful, it still is not on par with the Great Depression. The Great Depression was marked by four consecutive years of decreases in Gross Domestic Product (GDP), while the current recession is expected to result in four consecutive quarters of decrease in inflation-adjusted GDP. In fact, in the first year of the recession, the national GDP actually increased by 1.1 percent.

"During 2008, the first year of the recession, you would expect that the GDP would be decreasing," he said. "Well, one of the factors holding it up was exports. Exports continued strong in the United States through 2008." This year, however, exports are expected to drop by 10 percent.

That's just one example of how the national and state economies will continue to struggle as the recovery begins to take hold. Another example is the expected freefall in the commercial real estate market, especially in Arizona. "Commercial is the next shoe to drop and we have seen this pattern before," McPheters said.

"Even as you see residential [construction] begin to pick up, I think you can expect that commercial building is going to be very, very weak all the way through 2010 and probably 2011, because what we need to see is population growth come back and job growth to come back. There's no point in building retail space and office space if the jobs are not there and the consumer is not coming out to shop."

And it is consumers, who account for 71 percent of GDP, who really hold the key to the economic recovery. "The consumer is the only part of this economy that can bring us back," McPheters said. "Consumers are not going to come back into the game until home prices stop falling, until the stock market stabilizes, until they see unemployment rates have peaked out and job losses start to get smaller and smaller.

And the consumer has to have confidence to buy, and believe it or not, the consumer has to back off of their inclination to save their money." In March, the savings rate as a percent of disposable income was 4.2 percent, up from 2.6 percent six months earlier. While increased savings are considered a good thing in robust economic times, a pullback by consumers as an economy tanks can have devastating effects.

McPheters pointed out that for each 1 percent increase in the savings rate, approximately $100 billion are being pulled out of the consumer-spending stream. However, McPheters expressed confidence that the very calamity that sent our state and national economies reeling will eventually add to Arizona's attractiveness to new residents and businesses — falling home prices.

"Housing prices have now returned to the traditional level, where Arizona housing prices are now more affordable than the national average," he said. "In 2005 and 2006, we had come to the point where we were one of the least affordable markets. That has turned around and it has turned around very quickly. Of course that has been very painful."

How to close the gap

Hoffman agreed with McPheters, adding that he believes the state's economic rebound will be strong. "This of course is the big question: What kind of bounce will take place? Now, I'll have to say that the dramatic shakeout in prices in housing, while it has been absolutely disastrous for a number of folks and put a lot of pressure in a lot of different places, it might set us up for a more robust recovery than I would have thought six to nine months ago," he said.

"The thinking is really very, very simple; an attractive attribute of Arizona has historically been great climate, affordable housing and a place to get a job. That third aspect really doesn't exist right now, but it could exist if our economy recovers at a little faster pace."

In the economic downturns of the past four decades, Arizona has bounced back strongly, and Hoffman is confident history will repeat itself, especially if the state and Valley can re-create the environments that people from around the country have found so attractive. But Arizona's current budget crunch casts a long shadow over the prospects for recovery. In fiscal year 2009, the state's budget gap stands at $1.6 billion.

In fiscal year 2010, that's expected to almost double to $3 billion dollars. As the economy has worsened, unemployment has soared to almost 8 percent, foreclosures have skyrocketed and businesses have closed their doors. As a result, billions of dollars in revenue from income, property, sales and business taxes have evaporated. Conversely, the need for state services has exploded.

"We're really seeing the effects of the downturn in the economy. Not only are the state revenues significantly down, but also more citizens are in need of services," said Eileen Klein of the Arizona Governor's Office. In the past two months alone, the Arizona Health Care Cost Containment System (AHCCCS) has enrolled 50,000 people, she said.

Hoffman pointed out that in the past, $48 to $50 out of every $1,000 of personal income had gone into the state's general fund. Since 2006, that amount has been plummeting and is expected to hit around $33 by the end of this year. The state is now walking a tightrope of trying to increase revenues by raising taxes, while trying to woo out-of-state residents and businesses.

"I would argue that the state needs to be much more business friendly in terms of its tax structure, the quality of its work force, its job training programs. You can be business friendly in a number of ways. Having a lucrative market to sell into is probably the friendliest thing you can do for businesses," Hoffman said.

"Businesses look to where they can locate to make money, where they can produce at a reasonable cost, and sell and make profits. We need a more lucrative market here, we need higher incomes, we need higher income people residing here in the state of Arizona, [and] we need a friendly tax code for business."

Hoffman detailed what the state should and should not do as it attempts to plug the budget gap: The state should not impose taxes that distort the economy and create disincentives for business creation and expansion. Undue burden should not be placed on businesses, especially export-based businesses that are mobile. The state should focus on broad-based taxes with modest rates (compared with competitor states) that create the least distortion.

"If we had the income tax rates that we had in 1993, there wouldn't be a $3 billion hole; that'd fix it right there," Hoffman said. For now, Arizona Governor Jan Brewer has called for a temporary tax increase to bridge the budget shortfall. However, she has yet to say exactly where the tax increase will take place.

"There has been a lot of conversation over which tax would be best. We are certainly looking for the tax that will have the least negative effect on the economy while still providing the additional revenue needed to sustain us through the downturn," Klein said. To underscore just how hard the recession has hit Arizona, McPheters pointed out that the state is now ranked last in job creation — and climbing back to the top won't be easy.

"Can we come back from 50 to one? It can happen. We'll be a leader post-recession," he said. "Every recession, the Arizona economy rebounds much stronger than the nation as a whole. You have 50 years of evidence of that. Unfortunately, getting there will not be pretty; we have two ugly years ahead."