Fundmastery Blog

Kurt Brouwer January 28th, 2008

Every day, we read or hear dire reports of economic armageddon. But facts are stubborn things and this article by Brian Wesbury is full of pertinent facts. I do disagree with him on one point, but we’ll get into that later. Wesbury points out that, despite all the gloom and doom, the economy is still chugging along and a recession is unlikely [emphasis added]:

The Economy Is Fine (Really) (Wall Street Journal, January 28, 2008, Brian Wesbury)

‘It is hard to imagine any time in history when such rampant pessimism about the economy has existed with so little evidence of serious trouble…’

One of the few points on which I disagree with Wesbury is his first comment. I can remember a time — just after the Crash of 1987 — when the hysteria was even stronger than it is today (see The Stock Market Crash of 1987). Wesbury continues:

‘…True, retail sales fell 0.4% in December and fourth-quarter real GDP probably grew at only a 1.5% annual rate…

…Yet many believe that a recession has already begun because credit markets have seized up. This pessimistic view argues that losses from the subprime arena are the tip of the iceberg. An economic downturn, combined with a weakened financial system, will result in a perfect storm for the multi-trillion dollar derivatives market. It is feared that cascading problems with inter-connected counterparty risk, swaps and excessive leverage will cause the entire “house of cards,” otherwise known as the U.S. financial system, to collapse. At a minimum, they fear credit will contract, causing a major economic slowdown…

Many commentators express concern about the condition of U.S. banks. They believe banks are in deep trouble and this will yield a domino effect as banks cut back and then their borrowers have to contract their businesses. Yet, as I wrote, facts are stubborn things. Major U.S. banks actually made money last year despite all the bad loan writeoffs (see Despite Writeoffs, Major Banks Made Money In 2007). So, widespread bank failures are very unlikely. And, with the Federal Reserve acting to cut interest rates and the U.S. Treasury devising ways to help homeowners with bad loans, it is likely that mortgage losses will be contained. Wesbury continues:

‘…But in the U.S. today, the Federal Reserve is extremely accommodative. Not only is the federal funds rate well below the trend in nominal GDP growth, but real interest rates are low and getting lower. In addition, gold prices have almost quadrupled during the past six years, while the consumer price index rose more than 4% last year.

These monetary conditions are not conducive to a collapse of credit markets and financial institutions. Any financial institution that goes under does so because of its own mistakes, not because money was too tight. Trade protectionism has not become a reality, and while tax hikes have been proposed, Congress has been unable to push one through…

…The good news is that the U.S. financial system is not as fragile as many pundits suggest. Nor is the economy showing anything other than normal signs of stress. Assuming a 1.5% annualized growth rate in the fourth quarter, real GDP will have grown by 2.8% in the year ending in December 2007 and 3.2% in the second half during the height of the so-called credit crunch. Initial unemployment claims, a very consistent canary in the coal mine for recessions, are nowhere near a level of concern.

Because all debt rests on a foundation of real economic activity, and the real economy is still resilient, the current red alert about a crashing house of cards looks like another false alarm. Warren Buffett, Wilbur Ross and Bank of America are buying (see Bank of America Snaps Up Countrywide and Davis Selected Advisors Buys Merrill Lynch Stake), and there is still $1.1 trillion in corporate cash on the books. The bench of potential buyers on the sidelines is deep and strong. Dow 15,000 looks much more likely than Dow 10,000. Keep the faith and stay invested. It’s a wonderful buying opportunity…’

Downturns such as this are valuable because they remind investors, regulators, politicians and everyone else of that four letter word — RISK. We always have to be mindful of the downside potential in the financial markets and the economy. That is why diversification is such a useful tool for investors.

Nonetheless, the history of the past 25 years is quite clear. The economy is strong and resilient. It has been able to overcome double digit inflation and interest rates in the early 1980s, not to mention the S&L crisis. It easily weathered the Crash of 1987 along with the mild and short-lived recession of 1990-91, which coincided with the Persian Gulf War. The economy slumped a bit after the Asian crisis of 1998 and it weathered the recession of 2000-01, which coincided with the terror attacks on September 11, 2001 (see Greatest Economic Boom in World History).

Now, after five years of growth, things are slowing a bit, but periodic slowdowns should be expected. Soon, we will look back on this period in the same way we view all those other crises that were touted as the beginning of the end.

Hat tip: Steve Janachowski

• Business , Economy , Geopolitics , Money , Personal Finance
• Comments(4)

Did you enjoy this article?

• Subscribe to Fundmastery Blog by e-mail »
• Subscribe to Fundmastery Blog's RSS feed