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The American Engine Still Can

The Fed v. reality.

12:00 AM, Aug 14, 2010 • By IRWIN M. STELZER
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Still, all is not lost. Most economists believe that the economy will not drop into double dip territory, but will instead rack up low growth this year and next. Corporate earnings are quite healthy, close to the record highs reached before the downturn. Corporations have a $2 trillion hoard that they will soon have to spend or continue the emerging trend of increasing dividends, something that corprocrats are always reluctant to do since that means surrendering control of unused funds to their owners – the shareholders. Businesses are already increasing spending on equipment and software to replace stuff that is at the end of its useful life. The inflation-adjusted annual increases of more than 20 percent in each of the last two quarters were the most rapid since the latter part of the 1990s and far outstripped the rate of upturn that characterized past recessions.

Moreover, the Fed has not really emptied its quiver, even with interest rates effectively at zero. Last week it decided to stop shrinking its portfolio and instead to reinvest cash coming from maturing mortgages into Treasury IOUs, keeping long-term interest rates low to encourage businesses to invest and consumers to spend. Should it decide that things are getting worse, it can resume money creation, known as quantitative easing (QE), leading pundits to joke that Fed chairman Ben Bernanke might decide to captain the QE2, and is already preparing his job application. Whether he can steer the economy into more agreeable waters is not certain, since making it cheaper for businesses to borrow is, as Keynes once noted, like pushing on a string. So far, cash-laden banks say they can’t find credit-worthy small business borrowers, and cash-strapped borrowers say the banks won’t lend even to sound small businesses. 

Then there is fiscal policy. A new Congress will be in place in 2011, and is likely to have more deficit hawks than the existing bunch, many of whom won election by riding on Barack Obama’s coattails, now so frayed that these same politicians are asking him not to come into their districts. If the election returns follow the polls, the probability of the introduction of some sanity into federal fiscal policy will increase, especially if the presidential commission’s post-election report on the deficit can come up with suggestions for a politically acceptable mix of tax increases and spending cuts, perhaps using the new British government’s ratio of £4 of spending cuts for every £1 of tax increases as a guide.

All of which brings me to share prices. This week’s Fed confession that the economy was not moving along at the pace it had expected rattled markets, which sometimes affects the real economy by producing a drop in consumer confidence and spending. Take heart: After dropping about 3 percent on the day after the Fed’s announcement, the Standard & Poor’s index of 500 stocks hit 1093, the precise level that prevailed at the end of last year, and closed the week at 1079. For investors, although not for in-and-out traders, there has been much ado about very little: The tailwinds provided by good profits have been offset by the headwinds created by negative economic reports.

In the end, with the fuss created by the Fed report behind us, a longer-than-one-week look shows that jobs are indeed being created in the private sector, share prices are relatively unchanged, retail sales are sluggish but nevertheless up a bit, profits are ample, and businesses have started to reinvest. The American economy just might once again prove to be the engine that could.

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