The Outlook for the Economy as We Begin a New Year

As we enter 2012, it's a good time to reflect on where things stand in terms of the economy.  Many are still surprised at the weakness of the economic recovery and argue about who's to blame.  As discussed elsewhere, weak recoveries and issues of sovereign debt are common following financial crises.  Though better policies in recent years may have helped, they would not have led to a robust recovery.  What's the outlook for 2012?  Sorry to say it's likely to be a modest recovery shrouded by uncertainty.  The biggest potential threat is possible financial contagion from the European Debt Crisis.  For example, if a default of a major European bank or country led to another financial crisis, that would tighten credit globally, leading to another recession.  If significant financial contagion doesn’t occur and instead many countries in Europe are in recession, that will the hurt the US economy somewhat.  How much of an impact depends on the depth and severity of the European recession (which probably started in the Fall).  Combine that with a slowdown in emerging markets (China, Brazil, etc.) and exports won’t grow nearly as fast as in recent years.

Of course unexpected events could have a significant impact on the economy (for example, in 2011 two events that affected the economy were the Japanese earthquake, which disrupted global supply chains, and the temporary spike in energy prices, which depressed consumer spending for a period of time).  One possible event this coming year is turmoil in the Middle East.  This could include Iran, which has threatened to block the flow of oil and also may face more sanctions or worse in response to its nuclear program, or countries that experienced the Arab Spring in 2011, but may not end up with stable regimes.

The structural problems facing the US economy have not been resolved, though we’re making some progress.  Credit is easier than it has been, but is still tight by historical standards (one needs top notch credit to get the best rinterest ates).  Consumer spending has picked up somewhat in recent months, but its outpacing the growth in income, resulting in a lower savings rate, suggesting that its not sustainable.  Chances are the growth in consumer spending will decline in the first half of 2012.  Investment continues to be a strong point of the US economy, with investment in business structures and residential investment finally adding to economic growth (as they increase from depressed levels).  That doesn’t mean construction will boom, but it’s starting to bounce off of the bottom.

What about consumer and business confidence?  Though politics and policy are not helpful, the primary issue continues to be consumer balance sheets and the after effects of the financial crisis.  For example, estimates of pessimism increased a lot in late summer and early Fall (in large part due to Washington's handling of the debt limit), but at the same time, consumer spending started to rebound.  The big constraint is still deleveraging (reducing debt) and weak income growth.  Job growth has picked up somewhat as the economy begins to add about 150,000 jobs per month, but that will lead to only a modest decline in the unemployment rate.  As noted elsewhere, recent declines in the unemployment rate are somewhat misleading as the labor force declines.  If people start returning to the labor force, the unemployment rate may stagnate despite an improvement in employment growth.

Assuming the debt crisis in Europe is contained (just a European recession) and China experiences a soft landing, the US economy will continue to experience a modest recovery in 2012 as it heals from the Great Recession.