Moderate Growth Against Headwinds
By Joseph V. Kennedy
The coming year is likely to see moderate but not rapid growth. However, this forecast is jeopardized by a number of sources of uncertainty that could result in another disappointing year, similar to 2012. Here is why.
The economy remains weak. Economic performance over the past two years has been disappointing. After emerging from the recession, real GDP grew 2.4 percent in 2010, but this was followed by an anemic 1.8 percent the following year. Performance has not been any better this year (See Chart 1).
Recent history has been kinder for the material handling equipment industry, which has enjoyed a sustained recovery. Since at least mid-2012, the industry has seen a steady rise in new orders and shipments. The relatively high level of unfilled orders, especially compared to inventories, promises continued strong business absent a major jolt to the economy. Yet even this growth has slowed over the last six months (See Chart 2).
There has also been promising news on other fronts as well. Job creation has averaged 173 thousand over the last four months ending in October, lowering the unemployment rate to 7.9 percent. However, the labor force participation rate is 63.8 percent, well below its high of 66.4 percent at the beginning of 2007. This implies a loss of over 4 million workers from the economy.
In September housing starts rose 15 percent to the highest levels in four years. Housing seems to have hit a bottom and rebuilding in the Northeast should strengthen it even further. But the pace of recovery will continue to be constrained by the long backload of foreclosures in certain markets and the difficulty that all but the best individuals have in getting qualifying for a mortgage. Retail sales, which had declined throughout the second quarter of this year, have now rebounded, rising by 1.2 and 1.1 percent in August and September, respectively.
The Federal Reserve has pledged to pursue an accommodative policy until either unemployment declines significantly or inflation rises above its comfort levels. There is little sign that the latter will occur anytime soon. In addition to stating its intention to hold interest rates at exceptionally low levels through mid-2015, the Fed plans to purchase an additional $40 billion in mortgage-backed securities every month.
As a result of these trends, few observers think that the economy is in danger of tipping back into recession on its own. The more difficult question is whether economic growth will rebound sharply, surpassing the long run potential and making up some of the ground lost during the recession. Unfortunately, the more probable outcome is that growth gradually increases but remains below full capacity.
The health of the American economy can best be understood by looking at three different internal forces that are likely to compete for prominence over the next decade. The first is the growing amount of unfunded liabilities that continue to weigh down the system. The high level of delinquent mortgages and the growing amount of federal debt are obvious and easily measured. Others, such as the unfunded liabilities associated with Social Security and Medicare, are less visible but still widely known. Still others, including the significant amount of unfunded retirement benefits at the state and local levels, the impending collapse of the U.S. Postal System, and accrued debts of the Federal Housing Administration, the Pension Benefit Guarantee Corporation, and the Department of Education are often hidden from view. It will not be possible to pay everyone everything they think they are owed. The stability of the financial system and the health of the economy will depend partly on how quickly and fairly we deal with these financial imbalances.
Countering this is the strong underlying momentum of the American economy. America still has the best economic climate among all of the industrial powers. Much of this is due to the legacy of democratic government, free enterprise, and stable legal systems. We have one of the best trained, most dynamic workforces. Workers want to work and once they work, they want to spend a large portion of their income on consumption of all kinds. The economic climate remains relatively open to new firms seeking to grow by providing their customers with better products at a cheaper price. And the idea of growth and progress are firmly embedded in the American psyche. Given a stable economic climate these forces will quickly reassert themselves.
The third factor is the tremendous potential of new technology to transform sectors of the economy such as health care, education, government services, and energy that have traditionally been protected from the competitive pressures that manufacturers have traditionally faced. Innovations such as massively open on-line courses, medical apps, and smart meters are just the start of a transformation that could disrupt traditional business models. But realizing the full potential of this technology will likely require the same type of disruptive change that accompanied deregulation of the transportation and communications industries and reengineering in manufacturing companies. Incumbent powers are certain to resist these changes.
Together these forces argue for confidence about the future, provided that political leadership can reduce the economic uncertainty within its control. There is little question that this uncertainty is hurting economic growth. Although consumer confidence has risen sharply in the last few months, businesses remain tentative. American companies are used to dealing with economic uncertainty. But the present outlook remains clouded by four persistent sources of potential trouble. Because each of these is largely political in nature, they are especially difficult for companies to gauge and react to.
The first and most important of these is the “fiscal cliff” facing the United States. Due to the confluence of a number of unrelated decisions, significant tax increases and spending cuts are scheduled to take place around the beginning of the year. About the same time Congress will also have to vote on raising the debt ceiling. The Congressional Budget Office estimates that these changes would reduce the federal budget by 5.1 percent of GDP between calendar years 2012 and 2013 and lower GDP growth next year to just 0.5 percent. These changes include the expiration of the Bush tax cuts, a sequester on federal spending as a result of not having achieved a budget deal at the end of 2011, expansion of the Unearned Income Tax, and the ending of extended unemployment benefits. As of now, it is hard to see a resolution to this problem. The most likely outcome is that Congress will somehow manage to postpone the near-term risk of financial paralysis without dealing with the medium-term uncertainty caused by unsustainable deficits. Moreover, any attempt to withdraw the tremendous expansion of fiscal and monetary policy would almost surely constrain growth in the near-term.
Other major uncertainties occur abroad. First is the continued impasse in Europe. Richer countries remain unwilling to provide a wholesale bailout of their more troubled neighbors. This is partly because many of the neighbors remain unwilling to enact the severe policy changes that are needed to allow their countries to compete in the world economy. Although much of the debate has been focused on near-term budgets, this is really a fight about the long-term viability of the European model, especially as it has been practiced in the South.
In China slowing economic growth has combined with a troubled political transition to increase in political uncertainty. China has sufficient reserves to cover up any problems caused by imprudent infrastructure spending and bad debts. But the trouble associated with the upcoming leadership change is widely unappreciated in America and signals a deeper weakness in the system. No government that relies on central planning has ever succeeded in building a stable, competitive economy. China will not be the first.
The final area of uncertainty is in the Middle East. The Arab Spring continues to cast both a ray of hope and a shadow of uncertainty in Tunisia, Egypt, and Libya. But the continued violence in Syria and Bahrain threaten to spill over into a broader sectarian war that has global ramifications. Current U.S. policy seems paralyzed in response. More serious still is the possibility of war with Iran over its nuclear program. Combined these forces cast continued uncertainty over the source of much of the world’s energy.
In sum, we enter 2013 with less momentum and no fewer challenges than we had a year ago. The economic forces that traditionally create growth and innovation are unlikely to fully reassert themselves until the political uncertainties are resolved. Since the 2012 elections reaffirmed the status quo, there are few reasons to think this will happen soon. In this climate we should hope for better times, expect slow growth, and work on persistent problems.
Joseph V. Kennedy is the President of Kennedy Research, LLC which provides tailored analysis of legal and economic policy for a variety of clients. His past positions include Chief Economist for the Department of Commerce and General Counsel for the U.S. Senate’s Permanent Subcommittee on Investigations. He has a long history of working with manufacturing executives. He can be reached at email@example.com.