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An Expansion With Staying Power
This economy is stronger than many people think.


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David Malpass

I agree with Business Week’s February 13 cover story entitled, “Why the Economy Is a Lot Stronger than You Think.” The article begins:

You read this magazine religiously, watch CNBC while dressing for work, scan the Web for economic reports. You’ve heard, over and over, about the underlying problems with the U.S. economy — the paltry investment rate, the yawning current account deficit, the pathetic amount Americans salt away. And you know what the experts are saying: that the U.S. faces a perilous economic future unless we cut back on spending and change our profligate ways.

But what if we told you that the doomsayers, while not definitively wrong, aren’t seeing the whole picture?

Indeed. The durability and sturdiness of the current economic expansion have been systematically underestimated due to a fixation on consumption, interest-rate hikes (rather than the level of target interest rates), house prices, the fiscal and trade deficits, and comparisons to previous and very different expansions.

Unlike other expansions, this one was built on the dollar’s value moving out of deflationary strength and into reflation. It has therefore been an unusually steady and strong expansion — one buoyed by the 2003 tax cuts which were both well-timed and well-focused.

The current unemployment rate of 4.7 percent is a better indicator of the strength of this expansion than job growth since employment was relatively high at the end of the 2001 recession and labor-force growth has slowed. At the same time, household savings are high while consumer finances are not a weak link. Because the U.S. household sector is the world’s biggest net creditor, the 14 interest-rate hikes from the low 1 percent level of June 2004 left monetary policy accommodative and growth strong and steady.

If investment and savings are higher than currently perceived, as I believe to be the case, there are far-reaching implications for the dollar, consumption, profits, interest-rate hikes, tax receipts, and probably inflation.

To begin, the consumer can remain resilient, but the economy is more balanced today between investment and consumption than people think. Recent strong consumption data coupled with rapidly rising expectations for first-quarter GDP and investment growth back this up. Meanwhile, capacity utilization and the labor situation are probably tighter than thought. This has positive implications for consumption, investment, and corporate profits, although it represents upward pressure on interest rates.

Potential GDP growth is probably higher than assumed, while actual GDP growth is probably closer to potential (and to the Fed’s inflation tolerance). So, to the extent that the economy is bigger and stronger than people think, debt and the trade and fiscal deficits are not as big relative to the economy. The fast growth in tax receipts in recent quarters is probably more sustainable than people think, meaning the fiscal deficit may grow slower than many forecasts.

If investment has been more than stated, as I also believe to be the case, the economy is probably more flexible than many believe. A housing slowdown in this environment would be easily absorbed through growth in other areas of the economy.

Corporate profits will probably remain high relative to the rest of official national income. Capital’s share of income has been the highest since the 1960s, while labor’s share has been relatively low. This has raised concerns over fairness, the sustainability of consumption growth (if labor’s share of income is low), and a slowdown in profit growth if labor begins to get a bigger share. But I think both labor income and corporate profits can continue to grow strongly, in that investment in businesses and labor are creating more value than people think.

The piece-by-piece improvement in the perception of the economy has added to the durability of this expansion. Many businesses are still cautious on the outlook, leaving inventories low and cash reserves high and allowing Federal Reserve interest rates to stay low longer than they would have otherwise. Meanwhile, profit growth is more sustainable (as each quarter has shown); there’s more innovation in the pipeline than can be identified; and there’s likely to be more pricing power.

This expansion is sticking around.

– David Malpass is the chief economist for Bear, Stearns.



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