"The Frankenstein Recovery"

Economist David Levy is wary. While watching what appears to be a typical return to growth, he also sees much that doesn't fit the mold

By Robert Barker

Is the economy recovering -- or not? After April ended with a government report of 5.8% first-quarter growth in gross domestic product (GDP) amid a broad fall in stock prices, that's the question everyone has to ponder.

The economy is coming back, says economist David Levy, but in an unusually scary form. Levy, chairman of the Jerome Levy Forecasting Center, calls what's going on now in the economy "the Frankenstein Recovery." To find out why, and why he's expecting lower interest rates ahead, I reached Levy by phone at his Mt. Kisco (N.Y.) office. Edited excerpts of our discussion follow.

Q: What do you mean by "the Frankenstein recovery"?


I was trying to create a nice metaphor for an economy that in some ways looks like a typical recovery, in the same way a Frankenstein monster looks like a typical human being but has a lot of things that are out of place or are abnormal, that point to underlying instabilities and problems.

Q: So we shouldn't trust that the economy is off to the races after a near-6% growth spurt in the first quarter?


No, we shouldn't. As much as two percentage points of that can be nothing but [our] having had the warmest winter in history. We've seen in past cases where there have been abnormally warm January-February periods, that the first quarter has shown some outsized performance.

Q: O.K. Go on.


The other point is that...the measured output numbers will outperform what people experience in terms of income stability and job stability. We will see fairly decent productivity and fairly decent GDP growth over the remainder of the year, but in terms of employment growth and improving profit margins, I think the news is going to be disappointing.

Q: So, there's a gulf between how the economic numbers look and the reality facing companies and consumers? What does that spell for interest rates?


We've been advising our clients consistently that, even under the best of circumstances, we think the market has priced in much more tightening than the Federal Reserve is likely to actually execute.

Q: Is that because you simply see weaker growth, or are there other fears or considerations that may stay the Fed's hand?


I think some of both. And the fears get back to why this is, if we want to call it that, a Frankenstein recovery.

Q: Your words, not mine!


Most of what has happened that has been unusual about this business cycle all comes back to what we refer to as the Big Balance Sheet Economy. That is, an economy that, over a number of years, has seen assets and liabilities both grow much larger relative to income than we've seen in the past, and larger than is really healthy.

Q: Please explain.


There are three areas of concern. One is the excesses of debt to income, which directly relate to the Fed's inability to tighten quickly. Second, the obvious excesses that we saw in stock market valuations. And, although they've come way, way down from where they were, they're still historically very high, especially given what I think is a very uncertain outlook for corporate earnings. And, third, is physical overcapacity. All the [productive] assets were paid for with debt or equity, and when they're not performing they actually do represent a financial stress as well.

Q: Do you see these imbalances as combining to create an urgent problem -- a crash of some sort? Or do you see these imbalances as simply being worked out by a long, long period of muddling through?


First of all, they represent an increasing vulnerability. Now, that means that if you have the right catalyst at any given moment, something [bad] could be triggered.

Q: So we're vulnerable to a serious downswing.


Can we muddle through? I think that we're going to see some sort of long muddling-through process that may have some big bumps on the road. It won't be steady...and it's going to have to involve the household sector, too.

Q: Are you in the camp that thinks residential real estate prices are, if not in a bubble, growing unsustainably?


I don't think the bubble is so much in real estate prices as it is in the leveraging of real estate, which fits in with the general pattern. We clearly had what we would agree is a real estate bubble on the two coasts in 1989, let's say. Or in places in the Oil Patch if we back 10 years before that.

Q: I remember the "Tulsa Riviera."


But by and large, the [recent] rise in real estate has not been so excessive that you can say, "Gee, there is wild speculation going!" However, I do think that if we go through a more difficult period -- as I think we have to at some point in the next few years, where we are going to be muddling through and consolidating debt -- that's going to put some downward pressure on home prices.... If the economy gets weak enough in the next year or two -- weak enough to raise the unemployment rate a lot -- we're going to see a lot of problems with mortgage loans.

Q: What do you think will be happening with, say, the 10-year Treasury note over the next six months to a year? It's now yielding 5.12%.


The 10-year is certainly going to end the year lower than it is now, and I think it could be 25 to -- under extreme circumstances -- even 100 basis points [each point being equal to one one-hundredth of a percentage point] lower than it is. We're going to be looking at something that's in the 4s.

Barker covers personal finance in his Barker Portfolio column for BusinessWeek. His barker.online column appears every Friday, only on BusinessWeek Online

Edited by Patricia O'Connell