US Economic Outlook - What's the reality?

The US economic recovery looks to be getting a bit of a foothold, at least that's how investors seem to see it. But what's the reality? To be honest, if I knew where the economy was headed over the next 12-18 months I probably wouldn't be blogging about it - I'd be investing accordingly and profiting from the information. But everyone in the world has a vested interest in knowing where the economy of the US and the world economy is headed. Everyone has their own opinion. Despite the recent hint of optimism from investors, there's some things that I'd like to throw out there for consideration. The United States recovery is impacted by a host of factors from the tangible to the intangible and by unforeseen events.

Brief Economic Explanation

The economy is impacted heavily by a few key factors. Consumer spending represents the lion's share of economic activity (GDP). The economy is also impacted by government spending and business spending. A recession in fact represents negative growth in spending - spenders spending less than before. Spending is in turn impacted by the rate of savings (i.e. money being set aside to not be spent) and by the amount of money available to either save or spend. The amount of money available is known as the money supply. This is governed in large part by monetary policy. Monetary policy is a powerful force in determining what happens next. It is not something that has immediate impact, but it has a bigger impact than a tax cut or a government works program (which is essentially, spending).

How government spends its money (for example the ARRA stimulus spending) and how government collects money, is known as fiscal policy. fiscal policy can also be used to encourage or discourage consumers and businesses to spend or save their money, in particular ways. For example an Investment Tax Credit would lower taxes for businesses or consumers who make certain types of investments - thereby altering the behavior in a ways that suits the government objectives. In theory at least.

Another factor that influences business and consumer spending is psychology. for example, if people believe that unemployment will rise, they tend to spend less and save more in case they might be the ones losing their job. The same is true for business - if they expect unemployment to rise, they see less demand for their goods or services, so they need to supply less, which means, layoffs. Whether the unemployment would have risen or not, the psychology can lead to a self fulfilling prophecy or have other sorts of impacts as well.

One final consideration is that the US economy does not work in isolation. External economies impact and are impacted by the US economy. Who sells to or buys from the United States? How much do they 'trade'? That impacts the value of the dollar, it impacts demand and supply.

How does all this relate?

Again it's a complex system with millions of variables impacting what ultimately happens. It's impossible (for now at least) to do calculations on those levels. But there are some key factors that will influence where things are headed. These include, in no particular order;

(1) Housing sales / housing starts
(2) Automotive sales
(3) The demand for oil
(4) Government purchases and government debt
(5) The money supply / credit markets

Housing Sales

There appears to be good news in housing sales. Keep in mind that because of the recessionary pressure, new housing starts will lag behind sales - there's excess inventory.

Investors poured into stocks after Fed Chairman Ben Bernanke said the prospects for a near-term recovery in the world's largest economy appeared to be good. Also boosting confidence was a better-than-expected rise in U.S. home sales last month that helped relieve some of the fears about American consumers that have held stock markets down lately.

While that sounds positive, there's some interesting factors that have boosted this sort of consumer spending. There's the psychology of the recovery, which if it turns sour hurts sales. There's interest rates, which if they head upwards (as a result of monetary policy) would kill the recovery and there's a little tax incentive that is due to end in November 2009. That will definitely slow things down to some extent.

…first-time buyers rushed to take advantage of a tax credit that expires Nov. 30. Sales jumped 7.2%, the National Association of Realtors said yesterday.

"We've got tens of thousands of homes perfect for the first-time homebuyer and we've taken advantage of that," said George Hackett, president of Coldwell Banker Real Estate in Pittsburgh.

The risks to that healthy pace, however, are job cuts, mortgage rates and the looming end to the homebuyer tax credit. "I would not be at all surprised to see a dip (in home sales) at the end of the year once the tax credit expires," said Robert Dye, senior economist with PNC Financial Services Group.

How much of a slowdown once the credit ends remains to be seen. But while the credit is available people are being pushed into buying during the window. some of the demand is new demand, but some is shifting demand forward to get people to buy now while the tax incentives last.

Automotive Sales

The apparent success of the cash for clunkers has a lot of people excited about what it's done for car sales and/or the environment. As with the housing market, some of any incentive program is attributable to a temporal shift in demand. In other words people who might have bought in 4 months bought this month - cash for clunkers ends today after all. When else are you going to get a few thousand dollars from the government to buy a car?

Setting aside that the import brands seem to be outperforming the domestic brands and that many dealers opted out of the program early because of the administrative nightmare, there's still the issue of what has it done for auto sales long term? And what has it done, more specifically, for domestic auto sales? The staying power of the increased demand is tenuous at best.

Like homes, automotive sales are a large ticket purchase. Psychology has a larger than normal impact on the demand. And another demand influencer is the ability to get a loan to buy the vehicle. That is influenced in turn by monetary policy, which impacts credit markets, and therefore car loans.

Demand for Oil

Oil is always an interesting indicator. Oil is needed to run an economy. In many senses it's the blood of industry, and it's also important to consumers directly. When the price of oil rises, speculation aside, it means demand has risen. That in turn should be a good signal for the economy - oil being used means manufacturers manufacturing and consumers consuming. This is one of those world economy situations though.

Firstly, the oil spending is going offshore to among others, OPEC countries (not exactly the best of world citizenry). It contributes greatly to a national trade imbalance, which carries impacts and consequences of its own.

Secondly, demand for oil, and a rising price, does not predominantly come only from the United States any longer. China is becoming a serious player in the oil consumption game. Oil prices can go up without a requisite recovery in the United States.

What does that mean? It means inflation can more easily co-exist with unemployment and other recessionary indicators - a state known as stagflation.

Higher inflation means higher interest rates. Higher interest rates means more savings and less spending, as purchasing power is declining. Less spending leads to well, recessionary pressure. In theory this is all supposed to work to create an equilibrium, but it doesn't always work out for the best, especially in the stagflation scenario.

Government Spending and Government Debt

ARRA spending is supposed to start kicking in soon. If consumer demand doesn't pick up, the idea is that the government programs spending the money will pick up the slack in demand and keep the economy moving. Rather than re-iterating a well made argument from the Heritage
Foundation, take a look at this interesting read;

Budgetary restraint should be viewed as an opportunity to make an economic virtue out of fis­cal necessity. Simply stated, most government spending has a negative economic impact. To be sure, if government spends money in a productive way that generates a sufficiently high rate of return, the economy will benefit, but this is the exception rather than the rule. If the rate of return is below that of the private sector—as is much more com­mon—then the growth rate will be slower than it otherwise would have been. There is overwhelming evidence that government pending is too high and that America’s economy could grow much faster if the burden of government was reduced.

The deficit is not the critical variable. The key is the size of government, not how it is financed. Taxes and deficits are both harmful, but the real problem is that government is taking money from the private sector and spending it in ways that are often counterproductive. The need to reduce spending would still exist—and be just as compel­ling—if the federal government had a budget sur­plus. Fiscal policy should focus on reducing the level of government spending, with particular emphasis on those programs that yield the lowest benefits and/or impose the highest costs.

Controlling federal spending is particularly important because of globalization. Today, it is becoming increasingly easy for jobs and capital to migrate from one nation to another. This means that the reward for good policy is greater than ever before, but it also means that the penalty for bad policy is greater than ever before.

What does this all of this have to do with the economic recovery? If the ARRA money starts to kick in, there will definitely be an increase in demand. It may be inflationary on it's own, but not necessarily. The real worry is the government printing or borrowing money to finance the projects.

The government will have to borrow money from China or simply print more money. Either case has its own downside. However the simple matter is that if you increase the money supply, without increasing the overall economic output of the country, you have inflation. With such a huge increase in the money supply expected, you have the potential for very large inflation.

With housing and automotive spending having the potential to slip off the table, thereby exerting recessionary pressures, it would seem that the recession could drag on. However oil demand could exert inflationary pressures and government spending could do the same. The ultimate picture is still not clear.

Monetary Policy: The money supply

The more money that gets put into the economy, whether borrowed or printed, the bigger the inflationary pressure. So what does it look like?

Bad.

Again - what does the next 12-18 months have in store? Continued unemployment? Inflation? Recovery? There's potential for all of it. But as I've written in the past - it's still too early to climb aboard the recovery bandwagon just yet. There's still plenty that could go very, very wrong.