The Economic Outlook

The American economy as we have known it since the mid-1980s is quickly and not so quietly coming to an end. The question on everyone's mind is, when will it be over? It is fairly clear what must happen for the economy to recover - the difficult part is determining when it will happen. Recently there have been some small bright spots of economic news. Citigroup, Goldman Sacs, and a few other companies are posting stronger earnings and banks are making headway into clearing out bad loans. Many economists now believe the pace of economic decline will slow for the second quarter and perhaps reverse by year's end. That's the good news, here is the bad: We are entering the most dangerous and difficult part of the business cycle - the bottom.

The current recession has taken an enormous toll on jobs, profits, economic growth, inflation, credit markets, and stock markets (didn't think I'd forget that one did you!) because it is at its core a painful deleveraging process. Our economy has been running overloaded with debt and now we have to shed that excess debt, which is a very slow and painful process. Where do we go from here? There are really two major paths that I see the economy taking and a lot of gray area in between. Here are my two cents on the economy - no guarantee included!

The first road is the more pleasant of the two. In the remainder of this year some hard choices will have to be made by the Federal Reserve and the Obama administration. Much of the current improvement is the result of temporary boosts to consumer income from stimulus efforts that will fade by the end of the second quarter. If the recovery is to start by that time the government will need to engineer a rapid completion to the deleveraging. If they get it right we might expect the economy to bottom out at the end of the second quarter and then stay relatively sluggish through the rest of the year. Unemployment is all but certain to rise through most of the rest of the year. We will be lucky to avoid hitting 10%. Mild deflation is also probable through the end of the year, though I would not expect anything severe. The credit markets will recover slowly as banks get better capitalized and more certain of borrowers' credit, but don't look for major recovery until the job market improves (think Q2 2010). It will likely be several years before the economy is at full employment again (unemployment of ~5%). The stock market is probably already near a bottom and if the economy bottoms this quarter should make a strong showing through year's end, but then who can really predict the stock market anyway! That doesn't sound so bad right. The trick is what is required to get us there.

In order for the economy to start a sustainable, long-term recovery like the one described above a lot of things needs to happen simultaneously. First, the Federal Government needs to do three major tasks and has to get them right. 1. Taxes must remain relatively low and not unduly burden businesses or individuals (this means all taxes - even on "the rich"). 2. The $700 billion bankruptcy, excuse me stimulus, package must be spent wisely. This means spending on infrastructure, education, and investment: the three things that drive truly sustainable, long-term growth. 3. Regulation must be reasonable, clear, and as minimal as possible. Second, the Federal Reserve has to engineer a very soft landing and very, very careful recovery. This means the Fed must be prepared to soak up liquidity and raise interest rates to prevent another unsustainable bubble or sky high inflation (which is a real risk), without grinding the recovery to a halt. This is NOT a small feat! Third, financial firms must clean up the junk and stand ready to lend. This is probably something the market will take care of, but we should watch it closely.

And now for the second path I spoke of earlier...If the government and business fail to do those three things effectively and with perfect timing we will see at best sky high inflation from too much liquidity and rapid growth or a deep depression the likes of which the world has never seen.

Which outcome is more likely? The government's track record on these delicate issues is not very encouraging. I would hope that collectively we would have learned from history, but the election of the most liberal President in American history suggests otherwise. Some of the things Obama, Bernanke, and company are doing are good and I can almost see light on the other side except for the mountain of debt that is rising from Capital Hill. My best advice is to hope for the best and plan for the worst. Let your representatives know how you feel and that you care. Guard your retirement savings from inflation. And most of all...pray.