Commentary: Why the Bears Aren't Backing Down

Will consumers stop spending just as businesses regain confidence?

By Peter Coy

By late 1981, economists were sure that the recession that had begun in July was over. Forecasters surveyed by BusinessWeek thought the economy would grow nearly 3% in 1982. Wrong. The economy actually shrank more than 1% that year.

Could the conventional wisdom be wrong again? Sure. Despite a spate of favorable data, pessimists argue that the U.S. faces a long period of slow growth--or even a "double-dip" recession. They worry that the mild 2001 downturn left in place the imbalances built up during the late 1990s. "The recession was too shallow to create the efficiencies that a longer, deeper recession would have," says Donald H. Straszheim, president of Straszheim Global Advisors in Westwood, Calif.

Many economists believe consumers are getting tapped out even as the stock market and housing remain overvalued. And they worry that households and companies have overborrowed, while the U.S. is getting too deep in debt to the rest of the world. Says Morgan Stanley Dean Witter & Co. Chief Economist Stephen Roach, dean of the double-dippers: "The case for a double dip is just as compelling--if not more compelling--than a couple of months ago."

Certainly, history is on the side of the doubters. Five of the seven recessions since 1957 have been double dips. In each, the economy grew for awhile only to relapse. The severe recessions of 1973-75 and 1981-82 were actually triple dips, with three distinct periods of shrinking output. Says Roach: "The reason you get a double dip is that businesses start getting confident just in the face of what turns out to be a relapse in consumer demand." Seeing consumers falter, businesses cut investment and the economy slumps. If it happened in five of the last seven recessions, who's to say it can't happen in this one?

In the pessimists' view, vigorous consumer spending now is hardly cause for celebration. To the contrary, it may simply rob from future growth. Personal consumption rose at a 6% annual rate in the fourth quarter of 2001, and spending on durable goods rose at an unsustainable 39% rate. The binge was fueled by zero-percent financing on cars and aggressive discounting by retailers, as well as by warm weather that kept people shopping. People moved up purchases they would have spread throughout 2002.

Moreover, both free-spending consumers and businesses are reaching the limit of their ability to carry debt. Srinivas Thiruvadanthai, research director of Jerome Levy Forecasting Center in Mount Kisco, N.Y., points out that at various points last year, delinquency rates reached all-time highs for credit cards, consumer direct auto loans, and government-guaranteed mortgages. Default rates on junk bonds reached 11%, tying the post-Depression high set in 1991. And write-downs of commercial and industrial loans last year were the highest since 1991-92. Debt loads will eventually inhibit consumers from spending and businesses from investing, dampening growth. And low inflation makes debt more onerous, because debts can't be paid off with cheap, inflated dollars.

Overleveraged consumers can't expect much help from the markets. The stock market got so high that even the past two painful years haven't brought price-earnings ratios down to earth. The p-e ratio of the Standard & Poor's 500-stock index is 22 based on projected earnings--and 61 based on last year's earnings. Prices are also high from a historical perspective, according to Minneapolis-based Leuthold Group. It calculates a p-e that averages four years of past earnings and one year of projected earnings, and splits the difference between net and operating profits. Its p-e was 24 at the end of February. That's 19% higher than the median p-e since 1957 for periods in which inflation was 3% or less.

Nor will the housing market continue to bolster consumers. As stocks sagged the last two years, speculation shifted to housing, an unintended consequence of Federal Reserve easing. House prices rose 9% last year despite higher unemployment. Homeowners raised about $80 billion through cash-out refinancings, and spent about $50 billion of it. But that source of money is tapped out unless rates fall even further, which looks unlikely. And the housing bubble could burst if the economy stays weak. That would make it harder for consumers to qualify for new loans. Says James Grant, editor of Grant's Interest Rate Observer, quoting an economic truism: "Asset values are contingent, but debt is forever."

The mildness of the recession is the Achilles' heel of the recovery. A severe recession forces weak companies to liquidate. Their employees and assets are then redeployed more productively. But the recession that began last March was so shallow that many weak companies have clung to life. The problem is worst in sectors that have been buoyed by consumer spending, such as retailing and food. Says Straszheim: "If the heat is not on, it just doesn't get their attention."

The 2001 recession also failed to correct the trade imbalance. Ordinarily the trade deficit shrinks in a recession because imports fall. Not this time. Consumers' demand for imports, fueled by the strong dollar, remained robust. And exports fell because the rest of the world also slumped. As a net debtor to the rest of the world, the U.S. is living beyond its means. So far, foreign investors have been happy to finance U.S. spending. But as the U.S. debt-to-GDP ratio rises, they're bound to get nervous. A slowing of the capital inflow--let alone an outflow--could trigger a severe recession. Says Standard & Poor's Chief Economist David A. Wyss: "You can't continue to borrow $350 billion a year and rising."

Double-dip recession or chilly recovery--which will it be? Maybe neither. But don't say the bears didn't warn you.

Coy is Economics Editor.

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