The Case for Optimism on the Economy


With the prospect of a long, deep recession staring us in the face, are there any reasons for optimism?

You betcha!

The central characteristic of the American economy – resiliency – is now being severely tested. But there are ample reasons to believe it will pass that test. Simply put, even after this crisis the US will still have the world's largest, most dynamic, most productive, most innovative, most technologically advanced, most competitive and most venturesome economy. Combined with population and household growth (the only first-world, industrial economy that can so claim), the US still has the best prospects for sustainable economic growth (which is a good thing, because we will need to return to a growth path to be in a position to solve the many challenges we will be facing in the years and decades ahead).

What is the case for optimism? Past experience and the fundamentals.

“If sensible rescue efforts continue – and they will – the immediate crisis will quickly pass. Shell-shocked businesses and consumers won't recover rapidly from the trauma of recent months, especially as we now cope with recession. But the downturn shouldn't be prolonged: The economy here and those overseas should start to pick up no later than next spring.” So writes Steve Forbes, publisher of the magazine that bears his family name, in an essay entitled “Capitalism Will Save Us.”

Despite the crisis, Forbes points out, the global economy still retains enormous strengths. Between the early 1980s and 2007 we lived in an economic Golden Age: worldwide, 70 million people a year were joining the middle class. Even the much-maligned US economy has been doing well in recent years. Between year-end 2002 and year-end 2007 US growth exceeded the entire size of China's economy.

As a result, the world is flush with cash. It's frozen because of fear, but the important things is: cash is there. And the US remains the premier destination for investment capital. So the global boom should resume next year, slowly at first and then with increasing momentum.

One word of caution: if we continue down the path of criminalizing business failures (think KMPG, Arthur Andersen), we risk undermining the basic idea of limited liability, and the risk-taking it encourages and engenders. That would be catastrophic. Limited liability is arguably the single most important innovation of the modern age, the most significant enabler of the explosive economic growth, development and widespread affluence we have seen since the 19th century. The punitive and costly Sarbanes-Oxley Act, passed in a fit of Congressional pique to punish financial crime, has done no good but lots of harm.

Monetary Policy, Energy Costs, Housing
Jeffrey Lacker of the Federal Reserve Bank of Richmond agrees growth will return next year; he expects the US economy to regain positive momentum sometime in 2009 for several reasons. First, monetary policy is now quite stimulative. The federal funds target rate is 1 percent, below the expected rate of inflation. Second, the major shocks that dampened economic activity this past year have already subsided or are in the process of doing so. Energy prices have reversed most of the earlier run-up; that will free up a portion of consumer budgets for spending on other goods and services. And third, the drag from housing seems likely to lessen in the next year, and in fact, we should see a bottom in housing construction around the middle of 2009.

These are trying times, admits Lacker, but we have weathered economic downturns and banking distress before, both nationally and globally. The fundamental creative process that drives innovation and improves well-being over time has not been mortally wounded, and that bodes well for the long-term.

If there is a slowdown in the turnover of money – say a 5% decline – the impact on nominal GDP growth is no different than if the money supply itself shrinks by 5%. And that’s exactly what caused the sharp drop in growth (with some panic thrown in for good measure). This sharp drop in growth is due to a temporary drop in velocity, not a typical recession caused by fundamental, economy-changing events such as higher tax rates, tighter money, protectionism or other public policies that stifle innovation or entrepreneurship.

But there is good news. After ham-handing the rescue operation for months, the cavalry has finally arrived. The Fed has injected massive amounts of liquidity, driving the federal funds rate to roughly 1%.

Moreover, the Treasury Department has drawn a line in the sand. It has decided that no more banks will fail due to a lack of liquidity. Despite the downside this represents for the ideal of free markets, these actions by the Fed and Treasury will help unlock the credit markets and turn velocity upward. With velocity and the money supply both heading up, a "V" shaped recovery is likely.

Rather than being the first of several negative quarters of economic growth, economists like Brain Wesbury and Robert Stein of First Trust Advisers predict a healthy period of growth in the second half of 2009. To be precise, they expect real GDP to be flat in Q1-2009 but then grow at an average annual rate of 3% in the final three quarters of next year, with only a temporary hit to earnings. The Dow Jones industrials average should recover to 11,000 by the end of this year, with another 20% climb in 2009 all the way up to 13,250.

We Have Been Here Before
The US economy has blossomed for 25 years, and can and will again. If, however, we regress by adopting protectionism, higher taxes, too much regulation and other key policy mistakes, the effect on our economy could be devastating. With the prospect of a new Democratic administration and Congress, these are not insubstantial fears. The Bush tax cuts will expire after 2010 if action is not taken to extend them. The capital gains tax rate will go up; the dividend tax rate will go up; the death tax will jump from 0% to 55% in 2011. These automatic tax increases we have the makings of an economic calamity. Same goes for increased protectionism and new regulations. But it will be with eyes wide open.

Innovation is Key
Pessimism about America's future has been growing, at least until the recent election of Barack Obama. Yet beneath the gloom, economists and business leaders across the political spectrum are slowly coming to an agreement: Innovation is the best – and maybe the only – way the US can get out of its economic hole. New products, services, and ways of doing business can create enough growth to enable Americans to prosper over the long run.

But here's the conundrum: If money alone were enough to guarantee successful innovation, the US would be in much better shape than it is today. Since 2000, the nation's public and private sectors have poured almost $5 trillion into research and development and higher education, the key contributors to innovation. Nevertheless, employment in most technologically advanced industries has stagnated or even fallen.

The new field of innovation economics addresses this gap between spending and results. Economists are increasingly studying what drives successful innovation to learn how companies can get more bang from the bucks spent on R&D and higher education.

One of the hottest areas in the field is the use of government aid to cultivate "innovation clusters," or collections of local companies and academic institutions working together to create new products and processes. Ideally, those alliances would build on existing expertise in a region.

It's possible the longstanding partisan debate over tax rates and budget deficits may soon become a sideshow. If it is realized that the main purpose of economic policy is to spur innovation and growth, then the two political parties will have to stop fighting and coalesce around policies that promote innovation.

So let’s keep things in perspective. Reports of our demise are premature.

Dr. Roger Selbert is a business futurist and trend guy. He publishes Growth Strategies, a newsletter on economic, social and demographic trends, and is a professional public speaker ( Roger is US economic analyst for the Institute for Business Cycle Analysis in Copenhagen, and North American representative for its US Consumer Demand Index.