Keeping Exuberance in Check

It's arriving a lot sooner than expected and appears to be a lot stronger, so investors are warmly embracing the economic recovery. Too warmly, perhaps. Listen closely to TV stock jocks and Wall Street analysts, and there are echoes of the bullish exuberance expressed during the heyday of the bubble. People would be wise to ignore them. A surprisingly strong first half of the year does not guarantee a good second half or even a decent overall recovery. Thanks to powerful New Economy forces and heightened security dangers at home and abroad, there could very well be greater uncertainties facing the U.S. in this recovery than in past business cycles. Cautious optimism is the stance to take.

Behind the hype, the good news is that the U.S. economy has evolved to yet a higher level of efficiency. Higher productivity, a contingent workforce, and variable pay allowed companies in the recent downturn to give real wage increases to most employees even as they let some go. Despite rising unemployment, consumer spending remained exceptionally strong, and home prices actually rose. This rarely happened in past recessions. At the same time, supply-chain systems permitted companies to cut inventories at a record pace. So resilient has the U.S. economy become that September 11 didn't cause it any lasting damage. The amazingly fast market reaction to the Enron Corp. debacle, which forced companies to clean up their financial reporting, is testimony to this flexibility.

Yet this year is fraught with hazards. America remains at war, and the conflict could at some point easily jeopardize consumer and business confidence. Domestic security risks remain high. U.S. troops are fighting and dying in Afghanistan, and they are assisting the Philippines, Yemen, Georgia, Somalia, and Colombia in the battle against terrorism. A much larger battle possibly looms with Iraq.

The recovery is fragile as well and could possibly roll over into a "double dip" downturn in the second half of 2002. Double dips have occurred in five of the past seven U.S. recessions. The specter of Japan is worrying as well. It had its own bubble burst and recovered, but only to sink into a sea of deflation and stagnation for all of the '90s.

Restoring profits is the key to keeping this recovery on track. Unfortunately, that will be no easy task. While the downturn was mild, it hammered profits into the ground. CEOs are still in a state of shock at the sudden and sharp collapse of their bottom lines, and this weighs heavily on capital investment. Strong productivity should help rebuild profits.

But the Federal Reserve will also have to play an important role. It will soon come under intense pressure to raise interest rates as the recovery gains momentum and companies start raising prices. Fed Chairman Alan Greenspan has said he would tolerate a pickup in prices if that would help corporate profit margins. He believes that reclaiming lost pricing power after years of deep discounts will not by itself generate inflation. Strong productivity growth and competition will keep costs and the worst inflationary pressures under control. If Greenspan sticks to his beliefs, the corporate profit picture could improve sooner rather than later.

The U.S. is emerging from its economic downturn at a time of great uncertainty. It has newfound economic strengths, but it faces new risks as well. There are plenty of reasons for optimism--and even more for caution.

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