washingtonpost.com
New year, new hope for economic growth

By Neil Irwin
Washington Post Staff Writer
Friday, December 31, 2010; A01

As 2011 begins, the United States is poised for its strongest year of economic growth since the recession began three years ago.

Plenty of risks that could undermine the recovery remain, and it could take years of solid growth to get the United States out of its deep economic hole. Nonetheless, signposts for the economy are generally pointing up, as illustrated by a pace of growth that accelerated in the final months of 2010.

Among the reasons for optimism: A wave of government efforts to boost growth is starting to take effect, including a payroll tax cut beginning Jan. 1 and the delayed benefits of a massive Federal Reserve action announced Nov. 3. American consumers have made progress paying down their debts and increasing savings. And the stock market has risen steadily in recent months, with the Standard & Poor's 500-stock index up about 13 percent for 2010 heading into the final trading day of the year, lifting businesses' confidence and consumers' wealth.

The latest readings on the economy Thursday matched the rosier outlook: The 388,000 people who filed new claims for unemployment insurance benefits last week were the fewest since the summer of 2008, below the symbolic 400,000 threshold that to many economists is the line between a healthy and unhealthy labor market. (Analysts caution, though, that the data can be volatile, especially around holidays.)

Also Thursday, the National Association of Realtors said there were 3.5 percent more pending home sales in November, much better than expected and a sign that lower prices are pulling buyers into the housing market.

More generally, a recovery that seemed tentative and halting a year ago now appears to be durable and more deeply entrenched, having weathered a soft patch earlier in the year. Macroeconomic Advisers, one leading forecasting firm, estimates that the U.S. economy will grow 4.4 percent in 2011. Moody's Analytics expects 3.9 percent growth. Goldman Sachs envisions 3.4 percent growth.

Any of those numbers would represent an improvement over 2010. Although official government numbers are not out, gross domestic product looks to have grown 2.7 percent over the past year, Moody's estimates.

'Sturdier,' but still risks

"The economy is on sturdier legs now," said Robert Dye, senior economist at PNC Financial Services Group. "We're making a transition to a broader, more durable recovery."

He and other forecasters acknowledge that there are risk factors in this generally sunny forecast that could reduce the pace of growth or even spark another recession.

There is the ongoing contraction by state and local governments, which is sure to be a head wind for growth and which could spiral into something worse if a crisis emerges in the market for municipal bonds. Financial troubles in Europe could spill over into U.S. markets. The price of oil and other commodities could rise back toward 2008 highs - when gasoline soared above $4 a gallon - and reduce Americans' disposable income.

And U.S. interest rates could rise sharply if investors lose faith that long-term budget deficits will be reduced, that the Fed will do what is necessary to keep inflation from spiking, or that President Obama and congressional Republicans can reach compromises to keep the government functioning.

"You could end up with Congress and the president engaging in a lot of yelling and screaming over the next two years but not able to do much of anything," said John Silvia, chief economist at Wells Fargo. "And there may be more of a sense that we aren't getting federal spending and taxes in order in a way that would bring the deficit down in the future."

Even the forecasts of the optimists offer no economic panacea, given the deep hole the United States is in. Growth of 3 to 4 percent would probably be enough to bring the 9.8 percent November unemployment rate down only to about 9 percent, according to a consensus of forecasters.

And the unemployment rate could face upward pressure even as the economy strengthens. Many Americans appear to have responded to the weak job market by dropping out of the labor force entirely, giving up looking for work. If the proportion of Americans in the workforce rose back to its pre-recession levels, 3.6 million more people would be looking for a job. As they rejoin the labor force but cannot find jobs immediately, it would boost the unemployment rate.

Economic downturns that follow financial crises tend to last longer and have slower recoveries than more typical recessions. After the early-1980s recession, which was severe but not driven by financial turmoil, the United States had five straight quarters of growth at an annual rate of 7 percent or greater. Even economic optimists are not expecting such a boom in the near future.

Less debt

At the same time, some of the factors that have been major drags on the economy in recent years are starting to have a modestly positive impact. The biggest of these is consumers' shedding of debt.

Americans took on massive loans during the run-up to the recession and have been paying them down - and in some cases defaulting on them - since. They are making progress: Debt service payments were 11.9 percent of disposable personal income in the third quarter, according to Federal Reserve data, the lowest since 1999 and down from 14 percent just before the recession.

"Household balance sheets have improved significantly," said Bernard Baumohl, chief global economist with the Economic Outlook Group. "Americans have been de-leveraging for the past two years, and as a result households are much better positioned for the future."

And the financial system seems to be stabilizing, with banks no longer tightening the availability of credit, according to a Fed survey of senior loan officers. That, in turn, should mean small businesses that depend on bank loans will be better able to expand and hire in 2011.

In particular, looser credit from banks and other lenders could work hand in hand with the Federal Reserve's cheap-money policies. The Fed's near-zero target for short-term interest rates and $600 billion program of bond purchases now underway are more likely to help the economy if banks become more eager to lend that money out.

Few forecasters are expecting major improvement in the housing sector, which has been a drag on the economy for four straight years. But neither does housing appear set to be a major drain on growth. Residential investment constituted its lowest proportion of overall economic activity on record in the third quarter, meaning that even if it were to contract a bit, it would have little impact on growth.

Moreover, housing developers are building homes slowly and eventually will need to ramp up their production. Housing starts were at a 555,000 annual rate in November, roughly half the pace needed to keep up with long-term growth in the population. That is fine now, when there is still an excess supply of houses from boom years, but eventually those vacant homes will be filled up and construction activity will need to rise.

"Builders will eventually have to start ramping up new construction," Baumohl said. "The question is when."

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