Will the U.S. economy improve or worsen between now and Election Day? Three AEI economists share their thoughts.

The state of the U.S. economy will be a major issue in the 2008 presidential campaign. With that in mind, we asked three American Enterprise Institute economists to answer this question: “Do you expect the U.S. economy to improve or worsen between now and Election Day?” Here are their responses.

John L. Chapman

When considering the U.S. economy, one is reminded of Dickens’s A Tale of Two Cities: it is the best of times, and the worst of times. On the one hand, in spite of several concurrent challenges, America’s consumers and its entrepreneurial class have proven themselves remarkably resilient. Bolstered by record levels of non-farm productivity and a huge increase (more than 15 percent) in exports, the economy is on track to grow by 1.5 percent this year. Additionally, real corporate profits should grow slightly in 2008, and $150 billion to $200 billion in new private equity and venture capital investment suggest an enduring confidence in future growth. Fueled by an expansionary monetary policy, which has driven interest rates to artificial lows, and accommodative fiscal policies (including a $168 billion “stimulus” package), the United States may well avoid a “recession” in the technical sense of the word—that is, it may avoid two consecutive quarters of negative growth.

On the other hand, there is no denying the ominous economic signals. Always a useful near-term indicator, the Dow Jones Industrial Average is near bear-market territory, having experienced a 17 percent drop from its October high. So far this year, the economy has lost 400,000 jobs and unemployment has jumped to 5.5 percent; this is the flip side of increasing corporate productivity. Inflation has surged past 5 percent, due mainly to rising energy and food prices. Big increases in several industrial commodity prices guarantee lower profit growth in the near term, which in turn portends sluggish (or nonexistent) job growth. The U.S. banking and financial system is over-leveraged; coupled with the credit crunch, this guarantees further economic pain as assets are re-priced and losses realized. Finally, the weak U.S. dollar, propelled by the inanity of huge chronic fiscal deficits and accommodative monetary policy, guarantees an eventual spike in U.S. interest rates, which will slow growth.

Add it all up, and we have an economy that, even if it continues to grow past the 2008 election, will do so at a rate well below the postwar average. What about 2009 and beyond?

In the agrarian era (say, the 19th century), recessions were usually the product of “real” economic shocks, such as drought or war. But in industrialized capitalist economies, recessions are often the result of lousy government monetary and/or fiscal policies. In recent years we have witnessed the intentional debasement of the U.S. dollar for short-term gain; meanwhile, our political class has failed us on all counts in its pursuit of expanding the welfare state.

Only a return to sound money, coupled with government policies designed to encourage growth—such as unshackling our domestic energy sector, rather than raising taxes on it—will move us beyond our current challenges. That leaves us with a grim choice: either we experience a short corrective recession in 2009, or else we face an extended, 1970s-style malaise.

John L. Chapman is a research fellow at the American Enterprise Institute.

John H. Makin

The outlook for the U.S. economy remains highly uncertain and may be contrary to the Federal Reserve’s expectation of a modest pick-up in the second half of the year. The major positive factors, at least for second-quarter U.S. economic growth, have been stronger net exports, some evidence of possible stronger capital spending, and stronger-than-expected retail sales in April and May. The stronger retail sales probably reflected consumers’ response to the distribution of tax rebate checks. About $50 billion in rebates was distributed in May, and another $50 billion was sent out in June. The rebate checks, relative to past stimulus packages, were widely advertised and skewed more toward low-income households. American households living from paycheck to paycheck will probably spend most (if not all) of their rebate money.

Durable goods numbers have suggested some revival in capital spending. However, many firms have begun cutting jobs, as evidenced by the higher unemployment rate in May. Going forward, it is hard to imagine that these firms will be adding to their productive capacity by spending more on capital. Beyond that, a high level of economic uncertainty and a low capacity utilization rate (below 80 percent) argue for continued weakness in the capital spending sector.

Dollar weakness and sustained growth in emerging markets have helped to boost U.S. exports, which contributed 0.8 percentage points to growth in the first quarter and probably will contribute another percentage point in the second quarter. That said, the modest appreciation of the dollar that has accompanied the Fed’s move toward inflation fighting probably means that the biggest boost from exports will have been witnessed by the end of the first half of 2008.

Meanwhile, auto sales fell at a 25 percent annual rate during the three months ending in May. Sales of new and existing homes remain very weak, while house prices—having dropped by 16 percent since 2006, thereby erasing $4 trillion worth of real household net worth—are on track to drop by another 16 percent by the end of 2009. Foreclosures are rising rapidly, and vacant housing units continue to increase as well, providing the basis for continued downward pressure on housing prices.

Federal Reserve Chairman Ben Bernanke characterized the sharp 0.5 percentage-point rise in the May unemployment rate as unwelcome. But he said that the higher unemployment rate, together with recent data on the U.S. economy, affected the outlook for economic activity and employment “only modestly.” That remains to be seen. The rise in the May unemployment rate reflected an 11 percent jump in the number of unemployed workers during that month, the largest increase since 1974. Indeed, an unemployment spike of that size has always occurred during a recession.

Taken together, the crosscurrents in the U.S. economic outlook have taken estimates of first-half growth from zero percent to about 1 percent. My own estimate of second-half growth is negative 1 percent, below the current consensus of about 1 to 2 percent. The outlook is complicated by uncertainty over interest rates. Markets are currently expecting a 25-basis-point increase in September followed by another 50-basis-point increase by the end of the year. Under those conditions, my estimate of second-half growth would be negative 1.5 percent, with substantial downside risk in the fourth quarter.

John H. Makin is a visiting scholar at the American Enterprise Institute. This article was adapted from his latest AEI Economic Outlook, “The Fed’s Dilemma.”

Desmond Lachman

Short-term economic forecasting is generally a hazardous enterprise. However, the preponderance of evidence suggests that there will be a marked economic deterioration between now and Election Day. By early November, most Americans will believe we are in a recession, unemployment will have climbed toward 6 percent, and headline inflation will have increased to more than 5 percent.

Why am I so pessimistic? One reason is that the U.S. economy has yet to adjust to the recent surge in global oil prices. Even when adjusted for inflation, oil prices today are higher than they were during the 1979 oil price shock, which plunged the global economy into a prolonged recession. Over the next four months, as higher oil prices continue to threaten economic growth, consumers will get squeezed and headline inflation will jump even higher.

The present oil price shock is occurring in the aftermath of the worst U.S. housing and credit market busts of the postwar period. There is every indication that the housing crisis will intensify, which will reopen wounds in the slowly healing credit markets. Unsold housing inventories are at record levels, foreclosures are now rising at an alarming rate, and home prices at the national level—which have already fallen by 16 percent from their 2006 peak—are now declining at an accelerating rate.

Since late April 2008, the negative economic impact of the housing and credit market busts has been cushioned by a large (but temporary) fiscal stimulus package. In particular, the economy has benefited from the spending associated with $100 billion in tax rebate checks sent out over the past two months. One must expect that the temporary fiscal boost provided by the tax rebates will wear off long before the election, at which time the economy will be subjected to the full force of the oil price shock and the housing bust.

The U.S. economy will be front and center in the 2008 election race. Judging by the present campaign rhetoric, the debate will focus on whether the country would benefit from a smaller government and whether it needs to “change” its economic direction. What we should be discussing is the very real threat that a prolonged U.S. recession could pose to economic globalization, which has been the bedrock of U.S. and global prosperity for the past 25 years.

Desmond Lachman is a resident fellow at the American Enterprise Institute.

Source: The American

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