Economy: Cautious Optimism for ’05

The Wharton School spoke to four of their professors about the economic outlook for ’05:

Investors, consumers and businesses have had a fair share of concerns in 2004: high fuel prices, less-than-stellar job growth and volatile swings in the stock market, which remains well below the highs set four years ago. But by many measures the year is ending well. Oil prices dropped in December, hiring has picked up, and the Standard & Poor’s 500, thanks to a string of gains in the fall, returned nearly 8% from the start of the year through mid-December.

Will the good news continue in 2005? The smart money says the coming year will probably bring decent, but not terrific, gains in economic growth and stock prices, according to four Wharton professors. But they do see hazards in the deepening federal and current-accounts deficits and the falling dollar.

“I think it looks reasonably good,” said Wharton finance professor Jeremy Siegel, referring to the economy and stock markets. “I think we can have 3½% to 4% real growth [in gross domestic product], with very moderate inflation – 2 ½%.”

Corporate leaders recently polled by the Business Roundtable survey have similar expectations, forecasting 3.5% GDP growth in 2005. Similarly, Anthony M. Santomero, a Wharton professor on leave to serve as president of the Federal Reserve Bank of Philadelphia, has forecast 3.5% to 4% GDP growth in 2005, compared to the 3.75% he expects for 2004.

Wharton finance and economics professor Richard Marston says he, too, expects GDP to grow 3.5% to 4% in 2005. “That’s a healthy economy in its middle stage of expansion.” Corporate profits, he added, are not likely to grow as fast on a percentage basis as they have this year, because 2004’s strong profits provide a higher base for comparison. In 2004, it was comparatively easy for businesses to show big gains over the weak earnings of 2003.

Siegel predicts the stock market will produce average gains next year. “I can see returns in the normal range of 6 to 10%.” Bond prices could well fall, he cautioned, if the Federal Reserve continues to raise interest rates, as expected. “I think the Fed will continue to raise rates and probably will get to something like 3½% by the end of [2005].” On December 14, the Fed ordered its fifth hike of the year, lifting short-term rates to 2.25%, up from 1% last summer.

Siegel expects the yield on the 10-year Treasury note to rise to 5%, from the current 4.14%, by the end of 2005. That will push mortgage rates up ½ to 1 percentage point. Marston agreed, arguing that a Fed Funds rate of 2.25% is not high enough to head off rising inflation, now at about 2% (or 3.2% with food and energy costs included). The Fed rate needs to be above 3%, he said, adding that he remains “positive. I think the economy’s under control. It’s not expanding at a pace where [Fed chairman Alan] Greenspan is getting worried. I think the economy is healthy and people are starting to get jobs.”

….Despite the positive economic signs and market gains of the fall, several problems could derail the recovery next year.

For example, while Fed interest rate hikes are meant to slow borrowing and reduce spending to curtail inflation, a spike in rates caused by bond-market jitters could reduce consumer and business spending too much. In addition, in recent years the vibrant housing market has helped sustain the economy. But economists at the University of California, Los Angeles, recently forecast a drop in housing starts next year, due to high prices and rising interest rates. Millions of Americans have taken adjustable-rate mortgages on their homes; they will see their monthly payments rise in tandem with the Fed moves, leaving those households with less spending money.

Wharton finance professor David Musto said higher mortgage rates, falling home prices, or both, could have ripple effects that are not well understood. People stuck with homes that are not worth as much as they owe, and people worried about the high payments they would face with new mortgages, might opt to stay put rather than take new jobs. “People migrating to their most productive use is, of course, good for the economy,” he said. “If they are not doing that … we will see if that turns out to be a serious thing.”

Beyond the other obvious hazards – a worsening situation in Iraq or a major terror attack on the U.S – Marston worries about the danger that the dollar will continue falling against foreign currencies.

A low dollar helps American companies sell goods and services abroad by making them cheaper to foreign buyers. But the U.S. also relies on foreigners for loans, in the form of Treasury bond purchases, which make American deficit spending possible.

As the dollar becomes less valuable, foreign investors, including governments in China, Japan and elsewhere, could worry that they are losing money on Treasuries. Should they reverse course and start selling Treasuries, the dollar would fall further. To attract investors, Treasury-bond yields would then have to rise, causing interest rates for mortgages and other loans to go up as well, dampening U.S. economic growth. “I think the dollar is a concern,” Marston said.

The fate of the dollar is tied to two worsening deficits. The federal budget deficit results from the government spending more than it is taking in. The current account deficit is caused when Americans – their government included – spend more than they earn, financing the difference with loans from foreigners.

To avert a damaging slide in the dollar the government must tackle the two deficits, and the key to that is to reduce the federal budget deficit, Marston said. The current level of foreign financing of U.S. debt is “not sustainable,” heightening the risk of a depreciation in the dollar. Now that the U.S. is in economic recovery, “the government ought to straighten out this fiscal deficit.”

“Straightening out this fiscal deficit” still appears to be a lower priority for the administration than the war on terror (with which I agree) or tax reduction (nice personally, but you can’t have it both ways, can you?):

The White House is telling federal agencies to expect lean budgets next year, with congressional aides and lobbyists saying President Bush appears ready to propose freezing or even slightly cutting overall domestic spending.
Targeted would be all annually approved programs except for defense and domestic security. Excluding those two would leave a part of the budget the administration estimates will total $388 billion for the fiscal year that began Oct. 1. Also excluded are automatically made payments like Social Security and interest on the federal debt.

Bush’s stringent approach comes as record federal deficits that hit $413 billion last year hinder his ability to pay

for overhauling Social Security and extending his tax cuts. He also has tied the budget shortfalls to the weakening dollar and pledged to reduce red ink to help prop up the currency.

At his White House economic conference Thursday, Bush said he made “good progress” in holding the growth of nondefense, non-homeland-security programs this year to about 1 percent.

“What I’m saying is we’re going to submit a tough budget,” he said. “And I look forward to working with Congress on the tough budget.”

….As word of Bush’s still-evolving plans for domestic spending has seeped out, it has cheered conservative Republicans. They spent much of Bush’s first term criticizing him for letting spending grow too rapidly and pressuring congressional leaders to try clamping down on spending.

Excluding homeland security and emergencies like hurricanes, domestic spending has grown by 27 percent since Bush took office in 2001.

….”They’ve run out of excuses,” said Stephen Slivinski, budget director of the conservative-leaning Cato Institute. “They can’t blame anyone else.”

Still, Democrats and many moderate Republicans are certain to fight for their priorities when Congress begins translating Bush’ budget proposal to actual spending legislation next year.

“This tells you the administration’s priority is tax cuts over fiscal responsibility and providing central services to the American people,” said Thomas Kahn, Democratic staff director of the House Budget Committee. [AP]

The Boston Globe is not convinced or pleased:

President George W. Bush’s two-day economic summit was an exercise in political propaganda that attempted to hide the underlying economic problem for the administration over the next four years: The government is spending far more than it is taking in and needs to raise taxes to make up at least part of the difference.

….The Congressional Budget Office notes that federal spending, growing at a 3.5 percent rate in the 90’s, has soared to a 6 to 7 percent growth rate under Bush. Much of that can be attributed to the war against terrorism, but it made no sense to embark on the invasion of Iraq while simultaneously cutting taxes, as Bush continued to advocate throughout his first term. And the Medicare drug benefit, which Bush pushed through Congress last year, will put more pressure on the budget when it takes effect in 2006. The program lacks the price restraints necessary to keep it under control.

….Even if all unnecessary spending were eliminated, essential federal programs would require more funding than is possible when revenues shrink to an unreasonably low percentage of the gross domestic product – 16.5 percent, according to the CBO.
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Participants at the summit also barely focused on the decline of the dollar, but foreign investors’ tendency to put their money elsewhere is a sign that the Bush administration and Congress are pursuing polices that threaten American economic leadership. Despite Republican rhetoric, Americans are far from overtaxed. The Bush administration is underperforming in its essential role as guardian of the U.S. economy.

Irwin Stelzer of the Hudson Institute and the Weekly Standard expressed concerns on Tuesday but is ultimately “cautiously optimistic” as well:

The president’s decision to exclude from tomorrow’s White House conclave on economic policy anyone who might raise a dissenting voice, suggests that the meeting is intended more to provide Bush with photo ops than with new ideas on how to cope with the trade and budget deficits, the consequences of the falling dollar and rising interest rates, or continued dangerous reliance on imported oil.

Unfortunately, the administration appears to think that Karl Rove, the political genius whose knowledge of every district in Ohio contributed mightily to the president’s reelection, can also craft a sensible economic program. The decision to run economic policy “out of Karl Rove’s hip pocket,” says the Wall Street Journal, “sufficed in the first term when tax cutting was the main policy focus, but it isn’t likely to work for another four years . . . . Mr. Rove knows a lot, but we doubt he knows how to work out the next Long Term Capital Management failure, much less handle a dollar crisis.”

But look on the bright side. Bush enters his second term with an economy that is growing at an annual rate of around 4 percent. Inflation is tame, and the dollar’s downward movement has so far been more of a drift than a plunge. If past experience is any guide, a cheaper dollar might, just might, bring the trade deficit down to manageable levels.

The budget deficit also might be headed in the right direction. In the fiscal year that ended on September 30 the deficit came to $412 billion, the same percentage of GDP (news – web sites)–3.5 percent–as last year. That compares with forecasts that centered around $500 billion, or a 4.25 percent of GDP. Better still, reliable sources in the government assure me that on current trends the deficit will shrink to about half the current level as the economy grows. Assuming, of course, that Congress and the president finally meet a new expenditure they can do without.

Hee hee, good one.