A RECOVERY AT LAST / THE WALL STREET JOURNAL REVIEW & OUTLOOK ( RECOMMENDED READING )

The Wall Street Journal

REVIEW & OUTLOOK

OCTOBER 30, 2009

A Recovery at Last

But will it solidify into a durable expansion?

Yesterday's report of 3.5% growth in the third quarter confirmed what stock and credit markets have been signaling for weeks: The recession finally ended during the summer. Investors promptly bid up stocks after some jittery days, and we join in the relief that the worst is over and the risks of a deflation have passed. The question going forward is whether this recovery from a deep and unusual recession can turn into a durable expansion.

Consumer spending is up, but consumers can't continue to carry expansion if the job market doesn't recover.

We've been among the optimists expecting a recovery, and the GDP report reveals a normal upturn in the business cycle. This recession has been unusual because its deepest trough was triggered by a financial panic that induced something close to an investment panic. For all intents and purposes, the economy's heart stopped pumping for several weeks, and so the contraction has been especially sharp and deep.
But the very depth of that fall should naturally lead to a turn back up, and that is what we are now seeing. Inventories had been stripped to the bone and are now being rebuilt. After 14—count 'em, 14—consecutive quarters of decline, real fixed residential housing investment rose and added substantially to third-quarter GDP. Even business investment finally rose, albeit more slowly than will be needed to make an expansion spread and deepen. The economy's natural healing powers—its ability to wring out excesses and improve balance sheets—is working as it normally does.

Perhaps most striking has been the pace of consumer spending growth, though some of this seems to have been temporary and perhaps borrowed from the future. Consumers provided nearly two-thirds of the GDP increase, and auto sales alone represented roughly one percentage point. However, car sales soared in July and August due to the "cash for clunkers" program, only to crash in September after the program expired. Auto sales are unlikely to add as much pop in the coming months, barring a robust recovery in hiring and personal income.

The personal consumption share of GDP also rose to a modern high of 71% in the third quarter, while business investment came in at a lowly 12.1% of GDP. Consumers can't carry this expansion for long if the job market doesn't recover. And the modest growth in business investment reveals how wary companies are about taking new risks or committing to big-dollar projects or new job creation in the current political and economic climate.

The irony here is that the largest obstacle to turning this recovery into a durable expansion is now the very "stimulus" programs that were sold as a way to ensure recovery. Washington's Great Reflation—fiscal and monetary—eventually has to be wound down and paid for, and those looming bills now cloud the expansion outlook.

Whatever role the fiscal stimulus played in "saving or creating jobs"—and we don't see evidence of much—there's no doubt it did bust the federal balance sheet. With a deficit of $1.4 trillion in 2009, and $9 trillion more predicted for the next decade, every business and investor in America can see a huge tax increase coming right at them. The House health-care bill, unveiled yesterday, takes a major whack at the job creators in small business—to pick only one example. The uncertainty of the Washington policy outlook is a major dampener on future investment plans.

Likewise, the Federal Reserve's wide open monetary policy can't last forever, though you wouldn't know that from listening to some Fed governors. The Fed has now kept its target fed funds rate at essentially zero for nearly a year, and the pressures of this historically easy money are beginning to show across the world economy.

You can see the pressures in dollar weakness against the euro and other currencies, as well as against commodities like gold and oil. If you want to explain $80 a barrel oil despite weak global energy demand, look to the Fed. You can also see the pressures in asset bubbles building in corners of the global dollar bloc, such as the property market in Hong Kong, whose monetary policy is linked to the Fed's. And you can see the pressures in the hot money rushing into such emerging markets as Brazil, as investors look to diversify out of dollar assets.

Eventually, the world will force the Fed to tighten, and the danger is that it will do so abruptly and in a disruptive fashion. We think the Fed would have been—and would still be—wiser to tighten marginally now to relieve some of these pressures rather than have its hand forced. Better to slow first from 200 miles per hour to 150, rather than slam on the brakes on someone else's timetable.

We recognize that Washington's current policy makers aren't in the mood to take such advice, focused as they are on the political dangers of a 9.8% jobless rate. But the best way to nurture an expansion isn't to feed it recklessly with easy money and more "stimulus" spending in hopes of meeting the 2010 election timetable.

What this recovery really needs is for Washington to put an end both to its Great Reflation and its pell-mell government intervention, and let the economy's animal spirits revive at their own natural pace.

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