Let The Good Times Roll

So whether they realize it or not, Americans have reason to be optimistic. “Global Economy Gains Steam,” says the Wall Street Journal. “Profits Perk Up at Large U.S. Companies,” says Business Week. “U.S. Debt Markets Showing Signs of Improved Financial Health,” says the Financial Times. “Data Generally Consistent With Early Recovery,” Goldman Sachs is telling its clients. With reason. After well over a year of decline, the hard-hit manufacturing sector is picking up. For the first time in eighteen months, the Institute of Supply Management reported in August that its index topped the 50 mark that divides shrinkage from growth. Executives in some eleven industries reported that new orders are coming in, sales are up, and the prices they can get are rising.

America’s emerging recovery is finding support from other economies that seem to see light at the end of the long, dismal tunnel through which their manufacturing sectors have passed. Manufacturing activity in China, France, Australia and other countries increased last month, and the decline in activity in Germany slowed. Throw in an improvement in U.S. home sales, a rise in durable goods orders, business’ need to rebuild inventories, the fact that most of the $787 billion stimulus money will hit the economy in the last quarter of this year and some time in 2010, and we can look for continued improvement in the jobs market, with a return to what Christina Romer, chair of the Council of Economic Advisers, calls “more normal levels” of 5 percent to 6 percent in the next several years.

But not with complete confidence. For one thing, it is not clear that American consumers are prepared to follow King’s advice to “go out and spend some cash”. August back-to-school sales were off about 3 percent. Consumers bought only necessities to pack in their little darlings’ backpacks, and resisted attempts by retailers to end the era of deep discounting. Retail sales of women’s apparel (except, it seems, shoes), household goods, and even electronics were down in August from year-earlier levels for the twelfth consecutive month. Retailers fear that this bodes ill not only for the Christmas season, but for the much longer term.

Low and middle income consumers are still paying off credit-card debt, and upper-income Americans are trying to rebuild the wealth that was wiped out in the stock market declines and the collapse of the housing market. Whether this tight-fistedness will continue when the job market improves and incomes begin to rise significantly, no one can tell, but pessimists see a cultural shift to thrift that will affect consumer behavior far into the future. Which is not entirely bad news: an economy that moves from a negative savings rate to a more normal situation in which consumers save somewhere between 5 percent and 7 percent of incomes is likely to have lower interest rates and higher levels of investment.

Keep this in mind: no one has ever gotten rich betting against the American consumer. We may be witnessing a shift in purchasing habits rather than a permanent decline in the propensity to spend. Fashion specialist Nordstrom’s saw August sales drop 3 percent from last year’s level, and high-end department-store chain Saks experienced a plunge of over 20 percent. Perhaps most significantly, Abercrombie & Fitch, the trendy retailer that has tried to avoid price-cutting and other promotions, saw sales drop close to 30 percent. But price-cutting and bargain-offering chains Ross Stores, Costco, Target, Old Navy, Aerospatale and T.J. Maxx surprised analysts on the upside. “It’s really still a discounter’s and an off-price seller’s market,” concludes Ken Perkins, president of research firm Retail Metrics.

A more immediate problem is the condition of the commercial property market. Mike Kelly, president of asset managers Caldera, points out that the decline in rents and occupancy rates in properties bought during 2005-2007 has reduced incomes, and left these deals over-leveraged. There are some $700 billion of commercial-mortgage-backed securities out there, and by the end of 2012 some $153 billion in the underlying will come due. Deutsche Bank estimates that $100 billion of those will not have an easy time getting refinanced. Worse still, banks are holding $1.7 trillion — yes, trillion — in commercial mortgages and construction loans, and the delinquency rate on these is already so high that the Federal Deposit Insurance Corporation added 111 banks to its list of “problem banks” in the last quarter, bringing the total to 416, about 5 percent of all U.S. banks; these problem banks have combined assets of $300 billion.

Perhaps the best summary of the current situation is that we are back from the brink, the economy is improving more rapidly than many expected, but continuing problems in the commercial property and job markets, and consumer nervousness, leave the economy “still vulnerable to adverse shocks,” as members of the Federal Reserve Board’s monetary policy group put it.

Where we go from here will be determined in part by the outcome of the G-20 meetings. The finance ministers meeting this weekend in London will clear the way for their leaders’ meeting in Pittsburgh later this month, President Obama presiding. The assembled leaders will have two main chores, other than to ignore the more nonsensical proposals on global warming and international income redistribution. The first is to come up with some plan to reform the financial sector. The Americans want to increase the amount of capital banks must have to back their loans, the French are more concerned about reining in bankers’ pay, and the Germans want to make sure that no bank gets so big that it can, in Chancellor Merkel’s words, “blackmail governments.” My guess is that it will take a while, but in the end the governments will overcome banks’ resistance and force them to carry more capital, with those that are too big or too interconnected to fail being required to increase their capital by the largest amount, with negative consequences for their profitability. It is also likely that agreement will be reached to eliminate those features of bankers’ compensation that encourage short-term profit maximization and excessive risk-taking, but the American policy makers will not go along with the more draconian of French prime minister Sarkozy’s proposals. Merkel will be disappointed: it is unlikely that she or anyone else is prepared to break up the banks that she fears can blackmail her.

More important for the sustainability of the recovery will be the development of a coordinated strategy for winding down huge government deficits and pulling back the extra cash that has been pouring from the world’s printing presses. With the Obama administration unwilling or unable to staunch the flow of red ink, it falls to Fed chairman Ben Bernanke to lead the world in heading off inflation by withdrawing cash and tightening credit. He knows that. He just doesn’t yet know when to begin that politically unpopular process. He does know that the G20 leaders say it is too soon to declare victory over the recession. “It is important not to get carried away” [by the good news] . We call on central banks not to go out and raise interest rates tomorrow,” says Jorgen Elmsekov, acting head of the economics department of the Organisation for Economic Co-Operation and Development. Stay tuned.

Irwin M. Stelzer is a contributing editor to THE WEEKLY STANDARD, director of economic policy studies at the Hudson Institute, and a columnist for the Sunday Times (London).