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Feeling Better

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Two clouds hung over the financial markets in the late summer: worries about a European financial crisis and concerns that the U.S. economy might be tipping back into recession. Real GDP rose at a 2.5% annual rate in the advance estimate for 3Q11, which should put to rest fears that the U.S. economy has already entered recession. However, there are still some important uncertainties in the growth outlook for 2012. European leaders dodged a bullet last week, with the agreement on Greek debt (failure would have triggered a more immediate crisis). However, they did not put a number of problems to bed completely. So, how long will the good feelings last?

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Feeling Better

  1. 1. 6363 Woodway Dr Suite 870 Houston, TX 77057 Phone: 713-244-3030 Fax: 713-513-5669 Securities are offered through RAYMOND JAMES FINANCIAL SERVICES, INC. Member FINRA / SIPC Green Financial Group An Independent FirmWeekly Commentary by Dr. Scott BrownFeeling Better?October 31 – November 11, 2011Two clouds hung over the financial markets in the late summer: worries about a European financial crisisand concerns that the U.S. economy might be tipping back into recession. Real GDP rose at a 2.5% annualrate in the advance estimate for 3Q11, which should put to rest fears that the U.S. economy has alreadyentered recession. However, there are still some important uncertainties in the growth outlook for 2012.European leaders dodged a bullet last week, with the agreement on Greek debt (failure would have triggereda more immediate crisis). However, they did not put a number of problems to bed completely. So, how longwill the good feelings last?
  2. 2. The GDP data will be revised (and revised again), but the third quarter story is unlikely to change much.Consumer spending growth was moderate, better than was expected a month or two ago. Business fixedinvestment was strong, apparently fueled by robust growth in corporate profits. Inventories rose more slowlyin the quarter, which creates the potential for a pickup in production in 4Q11. The strength in capitalspending (expenditures for equipment and software rose at a 17.4% annual rate) suggests that regulations,worries about the federal debt ceiling, and anxieties about Europe have not been significant restraints at thecorporate level.However, consumer spending growth was fueled largely by a drop in the savings rate in 3Q11. Inflation-adjusted disposable income, a key driver of spending, fell at a 1.7% annual rate. Growth in nominal incomewas relatively strong in the first half of the year, but was offset by higher costs of food and energy. In 3Q11,nominal income growth slowed. Inflation cooled, but not enough to boost real incomes. A further rollback inprices could help in the remainder of the year and into early 2012, but we’re not there yet. Gasoline priceshave fallen from the peak in early May, but the level remains moderately high and appears to be leveling offin the near term.The key to the long-term consumer spending outlook is job growth. Most labor market indicators haveremained consistent with moderate gains in the near term – a limited pace of job destruction, but continuedrestraint in hiring. Credit is gradually getting easier for small, newer firms. The monthly ADP estimate ofprivate-sector payrolls has continued to show moderate job gains for small and medium-sized firms, but thepace is well below where it was in the early part of the year.Studies of past financial crises point to some simple policy prescriptions. Hit back hard and early. Don’t waitfor problems to become more ingrained. Global leaders and central bankers were relatively quick to respondto the subprime crisis three years ago. That doesn’t mean that everything was made okay. Rather,coordinated efforts prevented the crisis from getting a lot worse. Since that time, the record has been lessthan stellar. In the U.S., fiscal stimulus was much smaller than needed and poorly directed. Tax cuts (35% ofthe American Recovery and Reinvestment Act) did little to spur growth (but did add to the deficit). A third ofthe ARRA was aid to the states, which prevented bigger contractions in state and local government spending,but didn’t add much to overall growth. Less than a fifth of ARRA was infrastructure spending, which onewould expect to provide most of the oomph. Granted, the recession was a lot worse than was expected duringthe heat of the battle, but “re-elect Obama, things could have been a lot worse” does not make a verycompelling bumper sticker.Still, treading water in the U.S. is better than the flat-footed policy response in Europe. Granted, there areplenty of austerity advocates in the U.S. In normal times, one could make the argument that reducing budgetdeficits helps to lower borrowing costs, boosting business investment and aiding the overall economy (thatwas the argument in the Clinton years). However, austerity in recessions is a terrible idea. Greece is a goodexample. Higher taxes and government spending cuts have weakened Greece’s economy, making debtproblems worse instead of better. Nobody is arguing against reducing budget deficits in the long term.
  3. 3. Certainly, European and U.S. budget deficits are on an unsustainable trajectory. However, too much belttightening too soon risks dampening the recovery. The better policy is to try to boost growth.Focused entirely on price stability, the European Central Bank raised short-term interest rates earlier thisyear, repeating the same mistake it made in 2008 (in comparison, Fed Chairman Bernanke recently spokeabout making financial stability policy equal to monetary policy). On Tuesday, the ECB will have a newpresident, Mario Draghi, currently the head of the bank of Italy. However, the direction of the ECB is notexpected to change – and typically, a new head of a central bank has to prove he is tough on inflation. TheECB is providing liquidity to the financial system as needed, but could do a lot more at this juncture.The European debt agreement puts the major concerns about Greece off to the side for the present. However,it’s unclear exactly how much the European stabilization fund will be increased and how it will be financed.More troublesome, the agreement doesn’t do much to head off potential problems for Italy and Spain. Thegovernment debt situation in the UK is worse than in Spain and Italy, but borrowing costs for Spain and Italyare much higher. That’s because Spain and Italy do not have their own monetary policy. Recent researchbyPaul De Grauwe notes an inherent fragility in the monetary union. The ECB and the EU will have toaddress this at some point.

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