Reasons for optimism

The U.S. military has been resoundingly successful in meeting its objectives in the war with Iraq, but one of the casualties of that conflict has been the U.S. economy. This is most evident in the nation's job market. Businesses have resumed reducing payrolls, which, since peaking two years ago, have fallen by well over 2 million--equal to 1.6% of all jobs.

The current job losses are now comparable to those experienced a decade ago during that recession and jobless recovery. The current job losses are substantially more broadly based across industries and regional economies than they were a decade ago. Industries shedding jobs include all of manufacturing, commercial construction, wholesaling, retailing, investment banking, and, most recently, state government. Metropolitan areas experiencing measurable job losses include such wide-ranging places as Boston, New York City, Atlanta, Detroit, Kansas City, Dallas, Denver, Salt Lake City, Seattle, and San Jose. Even more disconcerting is that by this time during the early 1990s' business cycle, substantive job growth had already begun.

The Good News

While the current economic statistics appear bleak, the economy is expected to stabilize quickly and soon resume expanding. This optimism is based on an expectation that depressed investor, business, and consumer confidence will rally in the wake of events in Iraq. Indeed, since plunging to a nadir in mid-March, stock prices have rebounded over 15%, Economy.com's survey of business confidence has regained nearly half the decline experienced in the weeks leading up to the war, and both the University of Michigan and ABCNEWS/Money magazine polls of consumer confidence have risen measurably.

The economic weight of higher energy prices also has lifted quickly. The price of a barrel of West Texas Intermediate oil has fallen from a peak of close to $40 to well below $30. Consumers, who paid a whopping $75 billion (annualized) more on energy this February than a year ago, are now enjoying falling gasoline and home heating prices. Hard-pressed manufacturers and transportation companies also are quickly benefiting.

Optimism that the economy will quickly rebound is based also on the view that the economy is fundamentally sound.

* The excesses born of the stock market bubble, including overinvesrment in information technology and rampant corporate malfeasance, have been largely righted in the three years since that bubble burst.

* IT equipment and software have an economic life of less than four years, according to the Bureau of Economic Analysis. Most of the investment done in the months leading up to Y2K is now coming due for replacement.

* While corporate charlatans are still being uncovered, the most recent being at Health South and Royal Ahold, the discoveries are now fewer and farther inbetween. Moreover, the tough legislation fashioned in the wake of last summer's rash of corporate scandals should be a significant deterrent.

The consistently robust productive gains experienced throughout the economy's recent travails are testimony to its fundamental strength. Even abstracting from possible measurement error, productivity never declined during the 2001 recession and is currently about as strong as it has ever been. The benefits of these gains have accrued to workers largely in the form of solid compensation gains, although the persistently weak job market is now allowing businesses to reap some of the benefits in the form of better profit margins.

The Cautionary News

While the economy is expected to make a comeback, it is not expected to come roaring back. The collective psyche will mend post-Iraq, but it will remain fragile as homeland security and defense concerns will not completely fade. Code orange (1) alerts seem likely to be with us for some time to come, and security threats over nuclear capabilities in North Korea, a Palestinian homeland, Venezuelan succession, and Kashmir independence seem ready to emerge at any moment.

The teetering global economy also will remain a burden. Germany and Japan, the second and third largest global economies, already are in recession, and a range of economies--including France, Italy, and Mexico--are not far behind. Even previously strong economies--including India, Korea, and the United Kingdom--are experiencing a marked slowing in growth.

Consumers are likely to remain cautious spenders given the soft job market and the weight of high household leverage. Record and rising bankruptcy rates, mortgage foreclosure rates, manufactured housing delinquency rates, direct auto repossession rates, and consumer credit net charge-off rates signal that households are already under substantial financial stress.

The economy will get less support from monetary and fiscal policies, both of which have provided massive amounts of stimulus in recent years. From the point at which the economy's difficulties began--soon after Y2K--the federal funds rate target has been lowered from 6.5% to 1.25%, and the federal government's balance has swung from a surplus of over $250 billion to a deficit now over $300 billion.

The Federal Reserve Board is only one financial crisis away from a zero funds rate. Proposed alternative monetary policy steps in lieu of further rate cuts, including buying long-term Treasury, corporate, and mortgage-backed bonds, or working to lower the value of the U.S. dollar, appear inadequate, impractical, or even dangerous.

With the rapidly mounting federal budget deficit and the prospects for large and persistent deficits well into the future, there is a growing wariness of using fiscal policy to further support the economy. Policy makers appear likely to agree to an additional $350 billion worth of tax cuts over the next decade--including rolling forward into this year cuts in personal marginal tax rates now legislated to occur next year and in 2006, elimination of the marriage tax penalty, and changes to the alternative minimum tax. Given the seeming demise of the Bush Administration's efforts to eliminate dividend taxation at the hands of moderate Senate Republicans, however, this will likely be the end of the tax cutting. Even these tax cuts will just barely offset the economic drag from cuts endured by state governments that are struggling to fill in large and growing budget holes.

Fingers Crossed

The preconditions for an improving economy are now in place. If further terrorism or adverse geopolitical events can be avoided, the economy will soon find its footing. Given all that investors, businesses, and consumers must still contend with, however, the economy will likely not be in full swing until this time next year.

Notes

(1.) The Department of Homeland Security uses the term "Level Orange" although most media refer to it as "code orange."

RELATED ARTICLE: Economy Will Improve: But When?

In the latest quarterly Phoenix Lending Survey, lenders across the nation predicted a dramatic improvement in the economy. The open question, though, is when will the recovery take hold?

Highlights from the survey include:

* Three-fourths of commercial lenders expect dramatic improvements in the economy in the next six to 18 months.

* But lenders are split on the timing of the recovery: 40 percent of lenders said economic recovery would occur by year-end, 36 percent predicted improvement would occur in 2004.

* 60% of lenders said corporate tax incentives to create new jobs was the most important step to stimulate the economy.

* 40% said full implementation of the Bush tax plan was necessary.

* Lenders upgraded their expectations for the economy's performance from a D+ to a C.

For the complete report, e-mail rcollins(c)phoenixmanagement.com. Results for past surveys are posted at www.phoenixmanagement.com.

[c] 2003 by RMA. Mark Zaudi, Ph.D., is chief economist at Economy.com in West Chester, Pennsylvania.

Contact Zandi by e-mail: [email protected]

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