Is the economic sky falling, or not?

Rarely have perceptions of the U.S. economy been so divided. Some are sanguine

Part of the answer to this dilemma can be found by looking at recent history. In just the past four years, the U.S. economy has faced what seem to be insurmountable issues. The stock market crashed, deflation undermined asset values, 9/11 created uncertainty, corporate scandals cut into investor trust, the fog of war became real and record-breaking oil prices threatened U.S. consumers.

Despite these developments, the U.S. economy has grown for 13 consecutive quarters. In the past year, real GDP expanded by 4 percent, more than 2 million jobs were created, business-fixed investment expanded by 10 percent, housing sales hit all-time record highs and consumption grew by more than 6 percent.

Randy Kroszner, University of Chicago professor and former Bush Administration economist, calls it a "Rodney Dangerfield recovery" - it gets no respect. No matter what the data say, someone, somewhere seems to find a way to be disappointed.

THE INFORMATION REVOLUTION

Part of the problem is that the economy is experiencing a massive upheaval in the way it is organized. New technology is rapidly boosting productivity in just about every industry on the face of the earth. For example, manufacturing productivity in the United States has grown at an annual average of 6 percent in the past three years. This means that output can increase by 6 percent per year without any additional employment.

Online and mail order retail sales are growing twice as fast as brick and mortar sales. So far this change has not had a material impact on the square feet of retail sales space, but changes are inevitable. For example, the Apple iPod and other digital music players are transforming the music business. Music downloads are on the rise, while retail sales of CDs are declining.

Music is still selling well, but the size of the workforce and the actual number of retail outlets needed to deliver music to consumers are on the decline. As the Internet continues to expand and new technologies become more accepted, these changes will accelerate. The bottom-line impact is fundamentally positive for the economy fewer resources are being used to produce and deliver goods and services to consumers.

Nonetheless, these changes cause uncertainty. Jobs are being lost, and companies that refuse to alter the way they do business are faltering. Even businesses that attempt to compete may find it difficult because new technology is eliminating an industry or pushing out the middleman.

What is most amazing is that the pace of change is accelerating. The new era did not die when the NASDAQ collapsed. It takes time for new technology and its potential to be absorbed. As a result, it will be many years, if not decades, before the information revolution has run its course.

DROOPING DOLLAR

In the midst of this fundamentally good news for the U.S. economy, the dollar continues to fall versus the currencies of most major trading partners. The euro, for example, has climbed to an all-time record high versus the dollar. This has focused attention on the trade deficit (which reached a record level of $600 billion this year) and the budget deficit (a record $412 billion in 2004).

For some, these twin deficits are a sign of underlying structural problems in the U.S. economy. But, the United States has operated with both budget deficits and trade deficits for many years now without any severe problems. There is no evidence to suggest that this time is any different.

The budget deficit was $100 billion lower than forecast in 2004, and should continue to decline in the future. Thanks to an improving economy, overall government revenues grew 5.5 percent in 2004. Corporate tax receipts led the way, with a 43.7 percent increase, and in the third quarter, individual tax receipts jumped 12.4 percent from year-ago levels. The Congress seems to be more serious about controlling spending as well.

The trade deficit is a more complicated issue. The most important thing to understand is that when U.S. citizens and corporations buy more goods from foreigners than they sell to them, foreigners end up holding dollars. Those foreigners then have two choices: use those dollars to buy more goods and services from the United States, or make investments in the United States. Every dollar must find its way back to the States; they do not pile up in a warehouse or get stuffed in a mattress. They must come back.

So far, those dollars are being used for investment. Contract law, a stable political environment and high returns continue to encourage foreign investors to put money to work in America. If, as the pessimists fear, foreigners all decided at once to stop investing in the United States, they must still dispose of the dollars they earn from exporting to the United States. The only other option would be buying goods and services. In this case, the trade deficit would vanish. The world is a closed system - dollars do not disappear - and the trade deficit is less of a problem than many fear.

THE FED AND INTEREST RATES

The real reason for the decline in the value of the U.S. dollar is that the Federal Reserve is following a very accommodative monetary policy. The Fed has held the inflation-adjusted, or real, federal funds rate below zero for the past three years. The only way the Fed can hold rates this low is if it allows the supply of money to grow faster than the demand for money.

The price of gold is well above $400/oz., commodity price indices are flirting with 23-year highs and the value of the dollar is falling. An excess supply of dollars is reducing its purchasing power on world markets.

Early in 2004, many forecasters predicted that the Fed would not hike rates until after the election, or possibly 2005. Nonetheless, the Fed hiked rates five times in 2004 and is on track to continue hiking rates in 2005 until the federal funds rate reaches 4 percent.

These rate hikes will eventually stem the decline of the dollar and arrest rising commodity prices, but they will also boost long-term interest rates. Given current levels of economic growth and inflation, 10-year Treasury bond yields are likely to move to 6 percent in the next 12 months, as the entire yield curve moves up with Fed rate hikes.

THE 2005 OUTLOOK

In addition to increases in market indicators of inflation, measures of consumer prices are on the rise. Through the first 10 months of 2004, the "core" consumer price index increased 2.4 percent at an annual rate, nearly double its 1.3 percent annualized increase in the first 10 months of 2003. Consumer prices should continue to accelerate with inflation moving into the 3 percent to 4 percent range in 2005 and 2006.

Overall economic growth is poised for another good year. With businesses continuing to invest in machinery and inventories, and the trade deficit poised to decline, real GDP should continue to expand at a 4 percent rate throughout 2005. As the economy grows and corporate profits rise, the stock market is also expected to gain ground.

There is always a reason to believe that the glass is half empty, but with tax cuts in place and the Fed moving slowly to boost interest rates, economic growth and employment should remain strong. While inflation is lurking around the corner, it will not bring down this expansion unless the Fed falls significantly behind the inflation curve. The sky is not falling and the clouds that so many seem to see on the horizon are not as dangerous as they seem.