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This Recovery Could Be Built On Quicksand


Propelled by strong growth in the U.S., the world economy is on course to hit its fastest expansion in 20 years. The long-awaited rebound in capital spending by American companies is finally occurring, in response to favorable financing conditions, healthy profits, lean inventories, and expectations of mounting future demand. Exports are expanding at an annual rate of 10%, boosted by the dollar's decline. Productivity growth remains surprisingly robust, keeping a lid on costs. The majority of economic forecasters predict sound performance for the U.S. economy during 2004. Goldman, Sachs & Co. (GS) economists describe the economic outlook for 2004 as "fabulous," a word rarely used by practitioners of the dismal science. But the rosy consensus forecast for strong growth obscures the fact that the economy's expansion rests on substantial policy stimulus and massive lending from the rest of the world. Neither is sustainable at current levels.

THE U.S. HAS NEVER BEEN MORE dependent on policy stimulus as a source of growth at this point in an economic cycle. On a cumulative basis, the Bush Administration has provided more fiscal stimulus to the economy than did the Reagan Administration over a comparable period. According to Goldman Sachs, since the middle of 2001, personal tax cuts have contributed an average of 2.2 percentage points to the annual growth rate of real disposable income -- the largest-ever fiscal stimulus over a comparable time period. In the 36 months since President Bush entered office, the 10-year budget outlook has deteriorated by about $10 trillion, an unprecedented swing. Tax cuts account for about 35%, and spending increases account for about 28%.

For most Americans, however, tax relief will end in the first half of this year with the last slug of tax refunds. And with concerns mounting over the U.S. long-term budget outlook, the odds that President Bush will win support for making his tax cuts permanent are falling. The Senate has dealt an election-year blow to this goal by passing a new rule requiring at least 60 votes to approve any tax cuts in the next five years, unless they're financed by spending cuts or tax increases. Nor is additional stimulus from monetary policy likely. In recent weeks, Fed officials have signaled their inclination to increase short-term interest rates by yearend.

By this point in a normal economic cycle, a virtuous circle of mounting production, employment, and incomes and their multiplier effects on household consumption could be counted upon to make the expansion self-sustaining without additional policy stimulus. But this cycle has not been a normal one. According to the Economic Policy Institute, this is the first time since 1939 that the number of jobs has not recovered to pre-recession levels nearly three years after the recession's onset. Real weekly incomes fell last year for workers in the bottom half of the wage distribution. And overall labor incomes, excluding bonuses and one-time payments, have been virtually stagnant for nearly three years. At this point in a normal recovery, total real labor compensation would be up by about 2.6%. Instead, it is down by more than 3%. As a result of anemic job and wage growth, America's consumers are missing about $350 billion to $400 billion in income, compared with past cycles. Unless employment and wage growth pick up sharply soon, consumption spending is likely to slow significantly, jeopardizing the expansion during the politically sensitive second half of the year.

The other wild card in the economic outlook is the dependence of the U.S. economy on massive lending from the rest of the world. The U.S. current-account deficit, a measure of how much more the U.S. is spending than taking in, is more than 5% of gross domestic product and rising. The central banks of Asia are financing about 50% of this imbalance by adding to their already huge holdings of dollar reserves. Overseas investors and central banks hold about 36% of the outstanding stock of U.S. Treasuries. Their willingness to accumulate U.S. assets has helped sustain the low interest rates that have supported the U.S. expansion. But will the rest of the world lend to the U.S. at favorable terms and in the amounts necessary to finance large current-account deficits for much longer?

The continued expansion of the U.S. economy depends on major borrowing from private investors and central banks around the world. They will be following the upcoming U.S. Presidential campaign with attention and anxiety. By Laura D'Andrea Tyson


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