The Pollyanna Economy

Readers may have noticed that we have a soft spot in our heart for negative news about the economy. That’s because the business and popular press dwell on the postive and give short shrift to the other side (with the exception of the Financial Times).

So we have a tense geopolitical climate, global warming looking real, serious, and costly to remedy (if it can be remedied), corporate profits being saved rather than reinvested (i.e., they don’t see attracitve opportunities) and financial markets riding on a rising tide of liquidity and speculation.

Although Friday’s economic news looked positive (good GDP growth and adequate job creation figures), some weekend pundits pointed out all is not as it seems. Barron’s Alan Abelson noted that consumer spending exceeded income in 2005 and 2006. The last time that happened was the Depression. And Michael Panzer tells us at Seeking Alpha that manufacturer inventories are being cut, and inventory changes are a leading indicator of economic activity:

Despite the optimism that persists on Wall Street, there was more bad news from Main Street last week. Bloomberg writes:

Manufacturing in the U.S. unexpectedly contracted in January as factories cut production and reined in orders to trim bloated inventories.

The Institute for Supply Management’s manufacturing index fell to 49.3, the lowest since April 2003, from December’s 51.4, the private industry group said today in Tempe, Arizona. Readings less than 50 signal contraction.

The report suggests last quarter’s production slump may carry over into 2007 as construction slows and automakers trim inventories of unsold vehicles. A factory setback would restrain growth and keep Federal Reserve policy makers on the sidelines, neither raising nor lowering interest rates, in coming months.

“In the first quarter, we’re going to see some big drops in inventory accumulation,” said Elisabeth Denison, an economist at Dresdner Kleinwort in New York. “That will drag down economic growth.”

Indeed, the graph below suggests that the U.S. economy loosely tracks swings in the ISM Manufacturing index:

Another data point that says the future may not be as rosy as the past.

Contrast with the insistently upbeat message from Friday’s Wall Street editorial page:

The good economic news keeps rolling in….Let’s look at the record of this expansion compared with that of the sainted 1990s. Economist Michael Darda has been looking at the numbers, and yesterday he put out a side-by-side employment comparison of the first five years of the 1991-2000 expansion with the current one that began in the fourth quarter of 2001.

Between 1991 and 1996, the unemployment rate averaged 6.4%, compared with 5.4% from 2001 to 2006. Today’s jobless rate is now down to 4.6%. As for (inflation-adjusted) wage growth, it averaged 0.6% annually for non-farm workers in the first half of the 1990s compared with 1.5% a year so far in this decade. “This cycle as a whole has witnessed twice the average real wage growth than the first 64 months of the previous expansion,” Mr. Darda writes. For the last 12 months, real wages have risen even faster, at a 1.7% clip.

Anything else to worry about? Well, there’s always the “trade deficit,” though exports are now booming (up 10% last year), especially to the countries with which the U.S. has signed free-trade agreements. So moving right along, this week’s bad news is said to be the U.S. “savings rate,” which according to the official measure was “negative” for a whole calendar year for the first time “since the Great Depression,” as Martin Crutsinger of the Associated Press helpfully put it. Hooverville, here we come!

As a statistic, however, the official “savings rate” is nearly as useless a guide to prosperity as the trade deficit. In the government accounts, what is called the savings rate is literally income less consumption. But the government defines income too narrowly and consumption broadly. For example, “income” doesn’t measure capital gains (whether realized or not), the rising value of your home, or even increases in your retirement accounts.

Think about how you calculate your own personal “savings rate.” Do you merely add up what you make in salary in a year minus what you spend? Or do you sneak a peak at whether your IRA increased in value, or check the sale price your neighbor got on his home to figure out what you might be able to get for yours? By any normal definition, “savings” should include your increase in total assets — in other words, your gains in overall wealth.

For our part, these columns long ago began to watch a far more instructive figure known as “household net worth.” That number, released by the Federal Reserve, includes all assets (tangible and financial) held by individuals less their liabilities (mortgage and other debt). At the end of last year’s third quarter, U.S. household net worth had climbed to $54.1 trillion. That was an increase of more than $3 trillion over the previous four quarters. Rest assured, that’s a much higher figure than during “the Great Depression,” AP notwithstanding.

None of this means we should be complacent about economic growth. There are two genuine clouds on the horizon — namely, inflation risk and political risk. Inflation remains somewhat higher than is comfortable, and we still expect the Fed will consider further interest-rate hikes if today’s weak dollar and soaring commodity prices lead to a jump in the official inflation indicators later this year. As for politics, the Democrats now running Congress explicitly reject the tax cuts and freer trade that have helped to propel the current prosperity. If history is any guide, sooner or later this is a recipe for trouble.

Where to begin with this? First, the choice of 1991-1996 vs. 2001-2006 is spurious. The 1990-1991 recessaion was nastier and deeper than the 2001 recession. The banking industry was in terrible shape in 1991, and with banks crippled, there wasn’t much new lending to businesses. And the recovery, as a Bush 1 Treasury official reminded me recently, was slow because Greenspan was tardy in providing monetary stimulus (he appears to have overcompensated for that failing later in his career). 1993 and 1994 were lackluster years. By contrast, while 2001 was a tremendous blow to the collective psyche, and put a lot of spending on hold for a few quarters, we weren’t dealing with seriously damaged finacial institutions in the world’s two largest economies.

As for the real wages argument, I presume the writer used CPI as the basis for his adjustment, and if so, we have a problem. I dimly recall, and am confirming with people closer to the data, that the method of calculating CPI was changed in the mid-1990s and had the effect of lowering the nominal inflation rate by about 1%. That would just about entirely explain the difference in real wage growth.

Finally, it’s appalling that the Journal is defending consumers tapping into appreciated assets to subsidize their consumption. No responsible financial planner would advocate that. But this isn’t about responsibility, it’s about keeping confidence up (or maybe the confidence game going?).

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