Is Economic Outlook Growing Brighter? Maybe Not
Consider the evidence for a sunny forecast: Stocks are up dramatically from their early-March lows, with the Dow Jones Industrial Average rebounding from around 6,500 to nearly 8,500. The S&P Homebuilders Index is in positive territory for the year, and the banks and the Morgan Stanley Retail Index have rebounded.
Federal Reserve Chairman Ben Bernanke was unusually optimistic on Tuesday, saying to expect a rebound to begin this year. "We continue to expect economic activity to bottom out, then to turn up later this year," he said.
An article at SeekingAlpha.com says that Internet publishers "think the decline in display ad spending may have bottomed out at last quarter," and Viacom also sees "encouraging" signs. Oil is higher on recovery expectations, after it — and the Rogers International Commodity Index and the Moody's Industrials Metals Index — fell by roughly half from a year ago.
Plus, home sales are up in parts of California, Nevada and Florida hardest-hit by the housing bust, hinting that they might be stabilizing. An end to declines isn't the same as a reversal, of course — but it does mean that the taxpayers' billions being funneled to imprudent borrowers seem to be having an effect.
Now let's consider the evidence for this being a brief respite from a building thunderstorm.
The recent rally in the stock market was fueled by banks, but Standard & Poor's Ratings Services this week placed 23 U.S. financial institutions including Bank of America, Citibank, and Wells Fargo on a watch list for credit downgrades. Goldman Sachs' too-clever accounting trick designed to downplay significant losses isn't reassuring.
One reason we're in this situation today is that, thanks largely — but not entirely — to the Federal Reserve's excessively low interest rates, a credit bubble formed. Not only did that propel housing prices to unsustainable heights, but it meant broad economic recovery isn't possible until they fall back to a price supported by actual fundamentals. (We couldn't recover from the dot-com bubble until dot-com disasters like Pets.com were delisted and their assets liquidated.)
The bad news is that to reach a price supported by fundamentals, housing prices in many areas must fall further. As the Wall Street Journal reported last month: "I looked at Case-Shiller's index back to 1987 and compared it to federal data on average earnings. The result, rebased to 100 in January 1987, can be seen here. And it's alarming. By this (admittedly very simple) measure, today's home prices are actually more expensive, in relation to average earnings, than at the peak of the 1989 property bubble."
My own analysis in February reached the same conclusion, reporting that "buy-vs.-rent ratios in such areas remain far higher than historic norms, a sign that localized housing bubbles have yet to deflate." Translation: In some areas, at least, look out below.
Plus, the post-bubble credit crunch isn't limited to housing. Student loan lenders are bracing for defaults; the credit card industry is in turmoil; and the deflating of the commercial property bubble may prove to be quite problematic.
No wonder that NYU professor Nouriel Roubini's newsletter distributed early Wednesday warned: "Markets are getting very close to being irrationally exuberant. Although there are some positive indicators, like the narrowing of credit spreads, and some stock market rebound from the March 2009 lows maybe (sic) justified by potential green shoots of economic recovery, other indicators paint a much bleaker picture. The rise in oil prices, and the significant rebound in banking stocks may prove in hindsight to be overly optimistic."
Perhaps the most important question is whether we're more likely to experience inflation or deflation (a question now immortalized in song). Prices are falling now, of course, but when the federal government's printing presses are running nonstop, inflation is likely in the future. It's just a question of when.
An article in The New York Times this week by Carnegie Mellon University professor Allan Meltzer warned of a repeat of the stagflation of the 1970s. Back then, he writes, "the Fed's idea was to combat recession by promoting expansion, printing money and making it easier for businesses and households to borrow -- and worry only later about the inflation that resulted. That strategy produced a sorry decade of slow productivity growth, rising unemployment and, yes, rising inflation. If President Obama and the Fed continue down their current path, we could see a repeat of those dreadful inflationary years." A YouTube video features Rep. Ron Paul, the libertarian-leaning Texas Republican, pressing Bernanke on this point during his Capitol Hill appearance this week.
Those concerns seem prudent, especially considering that our government's response to a modest slide in GDP is 12 times greater than its response to the far greater downturn during the Great Depression. That means the most likely economic forecast could be not a quick rebound, but more of the same.