New Year, Same Problems

 | Dec 29, 2011 | 12:00 PM EST
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When making an economic forecast, I always consider the various scenarios that can unfold, each dependent on a myriad of variables. Every scenario has a certain probability associated with it. And one must consider the catalysts that serve as an impetus for any given scenario -- the how and why of a particular situation. With that in mind, I begin my outlook for 2012.

The first consideration is where we are now. Economic data came in a bit better than expected earlier in the fourth quarter, with improving small-business optimism and signs of health in regional manufacturing surveys. While these are reasons for optimism, they are only surveys and not hard data measured in dollars or output. Actual data on investment and spending released at the end of December demonstrated an economy lacking forward momentum. What are the reasons that the economy might be propelled forward? Conversely, what are the risks that can cause its engine to sputter further?

I don't see many significant catalysts for the economy to grow any faster and, absent adverse shocks, I believe GDP will likely continue to grow between 1.5% and 2.25%. But I do see risks to the downside. While I understand that the Economic Cycle Research Institute (ECRI), a well-respected economic forecasting firm, has made a recession call for the U.S. and has stood by its forecast despite better-than-expected economic news recently, I am not willing to assign a 100% probability to their forecast. Casting doubt on the recession call, The Conference Board's Leading Indicators recently ticked up, but the validity of the forecast data is debatable. That said, consider some of the main elements of economic growth: consumer spending, business investment, net exports and government spending. None of these areas are likely to surge forward in 2012.

Consumers will likely have trouble maintaining the spending growth seen in parts of 2011 because their incomes are not growing. They also need to rebuild savings, as housing and stock market values are still below 2007 levels, and an aging population is nearing retirement. They are also busy paying down debt, or defaulting on it. Companies are not hiring or giving pay raises because sales are not growing significantly. For two straight months, companies have reduced investments in capital equipment, and the investments they have made seem to be aimed at boosting productivity to alleviate the need to hire. All levels of governments are likely to cut spending, especially with the deficit rhetoric in Washington and the well-known travails of state and local governments.

Meanwhile, much of Europe is on the verge of recession, which portends slowing growth in China (Europe is China's largest export market). While China is not a big export market for the U.S., trade linkages from China's suppliers, which all import from the U.S., can hurt the U.S. economy one way or another. (I discussed trade linkages in two columns previously.)

One way the economy might find some staying power is if consumers aren't in quite as bad shape as some of the data suggest. Consumers may have higher savings rates than indicated, and the improved confidence we've seen recently could prompt them to part with some of that cash. Still, improved consumer spending is more of an upside risk than a base-case scenario since they are still unlikely to reduce their savings rate by much to increase spending.

But the biggest risk in 2012 is politics. It's an election year, and the extremely polarized political landscape has led to gridlock that threatens to damage consumer and business confidence, as it did during the debt-ceiling debate that led to a downgrade of the U.S.'s credit rating. Higher taxes and reduced spending to curb the deficit will directly cut into economic growth. Whether or not you agree with what the government spends money on, cutbacks are still cutbacks and they will reduce economic growth. Failure to extend the payroll tax cuts and unemployment benefits beyond the current two months (which I wrote about in "Austerity Measures Could Hamper Recovery") can subtract as much as a full percentage point from GDP growth, based on my estimates.

This problem is not limited to the U.S. -- political turmoil in Europe is a huge risk, too. Europe is still not fixed. Intransigence by politicians and the unwillingness of the European Central Bank to take more-decisive action can undermine the global economy.

My bottom line calls for continued lackluster growth and high unemployment in 2012 -- there are no catalysts that I foresee propelling the economy to a faster track. GDP growth in my base-case scenario is barely sufficient to keep up with population growth and productivity gains, thus unlikely to reduce the ranks of the unemployed noticeably.

This assumes no adverse shocks -- and there are considerable risks to the downside that can't be ignored, especially those related to politics and fiscal policy on both sides of the Atlantic. In fact, these downside risks, along with the influence of variables that will inevitably surface along the way, can tip the U.S. economy into recession in a more pessimistic, but not unrealistic, view.

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