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Don't Mistake the Economy's Sparklers for Fireworks

By Steven Pearlstein
Friday, July 3, 2009

As we officially enter the second half of 2009, some stock-taking is in order.

Has the economy hit bottom, and is the recovery about to begin?

Is it safe to get back into the stock market?

Is it time for businesses to stop cutting and start investing?

Can the government begin letting up on monetary and fiscal stimulus?

The right answer to all of these questions is probably "no."

Certainly the economy and the financial system are in much better shape than almost any of us would have predicted as the year began. At the same time, the midterm outlook is nowhere near as rosy as suggested by the consensus forecasts from Washington or the second-quarter rally on Wall Street.

Given the size of the credit bubble, the amount of overcapacity that was allowed to develop and the staggering amount of wealth that has been lost, it would be foolhardy to expect the recession to be so shallow or the recovery so robust.

Government policies, certainly, have helped to moderate the pace of the adjustment and prevented it from spinning out of control. But the process of de-leveraging balance sheets and getting spending in line with incomes is nowhere near complete. Until they are, unemployment will continue to rise, businesses will continue to fail, and the economy will alternate between growing slowly and not growing at all.

We got a hint of all of this yesterday when the government reported the loss of 467,000 more jobs, bringing the number of jobs down to where it was back in March 2000. Stock markets here and around the world fell sharply on the news. And with tax revenue evaporating, some of the biggest states are being forced to curtail basic services and pay their bills with IOUs.

That's not to say there aren't some positive signs.

Monthly job losses have slowed, households have cut back on their debt, and some businesses have been able to float new issues of stocks and bonds.

Housing prices have begun to bottom out in some of the hardest-hit markets, and consumer confidence has recently improved. There are signs that manufacturing activity has begun to pick up, and even auto companies are suggesting their sales have bottomed out.

Most significantly, stock prices -- long viewed as a leading indicator -- rebounded nearly 40 percent from their lows of early March before giving back some of gains in the past two weeks.

One way to look at these developments is that they foretell a strong and sustainable recovery after an equally sharp recessionary decline.

A more likely explanation, however, is that the economy has merely pulled out of a free fall, and that for the next several years it will oscillate between sluggish growth and modest decline until the necessary adjustments and rebalancing are completed.

In this more realistic view, consumers who over the winter put off just about any purchase have decided that it's now safe to do a little shopping -- even as they continue to pare back their overall consumption.

Factories and stores that for the past six months have been living off unsold inventories have now reached the point of needing to replenish their shelves -- but without any expectation that sales will return to pre-recession levels anytime soon.

While investors and money managers rushed back into stocks once the threat of financial collapse had passed, it's hard to see how the overall level of stock prices can be justified by current or expected levels of corporate profits.

Even the dramatic rebound in commodity prices looks to be driven more by speculation than any genuine increase in global demand.

Even now, it is still not apparent where the growth will come from to drive a robust recovery. With unemployment continuing to rise to generational highs, and households still overburdened with debt, consumer spending is likely to remain sluggish for years. Strong export growth also seems unlikely, given that the rest of the world is in worse shape than we are.

The best hope for a sustained recovery may lie with a spurt of business investment in new technology that enhances productivity. That's the story of the economic recovery and expansion of the 1990s. And unlike growth driven by excess consumption and financial speculation, growth driven by investment, innovation and productivity has the added advantage of being more enduring and more widely shared.

Those qualities sound particularly attractive as we wind up a "lost decade" for the American economy -- a decade in which, when measured by jobs, incomes and national wealth, we'll end up pretty much where we began.

Have a happy Fourth.

Steven Pearlstein can be reached at pearlsteins@washpost.com.

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