With Rosy Predictions, Pundits Missing 2006's Warning Signs

By Steven Pearlstein
Wednesday, January 4, 2006

The columnist who tries to predict the future of the economy or the financial markets is a fool -- but no more so than the army of forecasters, money managers and economic policymakers who have been doing just that as part of the annual New Year ritual.

The consensus view, in case you've been on a beach reading Dan Silva spy novels these past two weeks and missed it, is that everything is going to be peachy-keen in 2006. Economic growth will slow only modestly from last year's unsustainable spurt; inflation will remain in check; the air will be let out gradually from the real-estate bubble; energy prices won't get any higher and probably will retreat a bit; the transition at the Fed will be seamless; the trade and budget deficits will shrink; the dollar may drift down, but only a bit; and stocks will post respectable gains.

Oh, and yes, purchases of new golf equipment will trim three strokes from your handicap.

Okay, so last year did turn out better than we worrywarts would have imagined. The economy's ability to withstand energy-price spikes, hurricanes and the Republican political meltdown was truly impressive. And yesterday's New Year rally on Wall Street demonstrated the widespread desire to believe in macroeconomic magic.

But reduce it to its bare essentials, and the story of 2005 was that oil producers proved just as willing to lend us the money to buy oil that we otherwise could not afford as the Japanese and Chinese have been to lend us the money to buy cars, jeans and flat-screen TVs. The arrival of this newest credit card from the Middle East may have allowed us to live above our means for yet another year. But let's not fall into the trap of confusing that with long-term economic health.

While the signals coming from the economic pundocracy may be solid green, the ones coming recently from the marketplace are flashing yellow. A middling Christmas season for retailers. A bicoastal housing boom that has already begun to abate, with an initial 10 to 15 percent drop in prices from speculative highs. A stock market that couldn't sustain a year-end rally despite record profits. A bond-market yield curve that makes it no more expensive to borrow money at a fixed rate for 30 years as for one year.

Other warning signs: A corporate sector unable to find a more profitable use for its record retained earnings than buying up its own stock or overpaying for questionable acquisitions. Hedge funds so flush with cash that they are lending money into a commercial real estate bubble, bidding up the price of gold and financing hostile takeovers. Pay packages for corporate executives and investment bankers up 30 percent in a year in which investors were lucky to eke out a 3 percent gain.

This is not to argue the economy is hurtling toward a crackup. The strength of the economy over the past year -- indeed, over the past 23 years, during which there have been but two relatively shallow recessions -- speaks eloquently of the resilience that comes with the globalization of trade and capital flows.

At the same time, I have a hard time squaring so many disquieting realities with a consensus forecast that has the economy gliding into some magical macroeconomic equilibrium.

A more likely scenario, it seems to me, is a 2006 in which the economic chickens finally come home to roost. Annual growth rates will fall from their current 3.7 percent to somewhere below 2 percent before the final quarter as government deficits are trimmed and households stop spending down their home equity. Inflation will reach 3.5 percent as key workers finally demand their fair share of productivity gains, health care and commodity prices continue to rise, higher energy costs work their way into the economy, and import prices spike in response to another steep drop in the value of the dollar. As economic growth slows, stocks will continue to drift sideways, snuffing out a nascent boom in corporate capital expenditures. Meanwhile, the long bull market in bonds will finally end as interest rates rise -- the result of heightened inflation expectations, continued monetary tightening by the Fed and a newfound reluctance of foreigners to invest their trade surpluses in dollar-denominated Treasury bonds.

The one likely bright spot in this scenario is the export sector, both manufacturing and service, which will benefit from a weaker dollar, continued robust growth in China, India, Eastern Europe and Latin America, and a revived Japanese economy.

At the same time, additional risks include excessive lending to developing countries, a restructuring of the U.S. auto industry, a hit to corporate profits as a result of tighter pension rules and a banking crisis triggered by a collapse of several highly leveraged hedge funds. All of these are risks that Washington policymakers could address but in an hotly-contested election year probably won't.

Will things play out exactly this way? Surely not. But if history is any guide, the odds in favor of it are no worse, and probably a bit better, than the remarkably rosy scenario embraced by Washington and Wall Street.

Steven Pearlstein will host a Web discussion today at 11 a.m. at washingtpost.com. He can be reached atpearlsteins@washpost.com.

© 2006 The Washington Post Company