2012 Outlook

The Lehmann Letter (SM)

The economy will improve gradually in 2012, much as it did in 2011. Even employment will make slow gains, and the unemployment rate will gradually decline. The economy won't rebound sharply, as it did following the 1981-82 recession and earlier recessions, because the recent recession, unlike those earlier recessions, followed on the heels of an asset bubble and bust.

Those earlier recessions followed a simple course: The economy expanded rapidly due to easy-credit conditions and then lurched into recession as the Fed boosted interest rates to restrain inflation. Then, as soon as higher rates dampened inflation, the Fed shifted back to an expansionary low-interest-rate policy and the economy snapped back.

Think of the Fed as a rider on a frisky horse. The horse galloped (economic expansion) when the Fed relaxed the reins (low interest rates), but slowed to a walk (recession) when the Fed pulled back on the reins (high interest rates). As soon as inflation came under control, the Fed relaxed the reins again and the economy popped up.

In that old economy, with its stop-start characteristic, cyclical industries like home-construction and auto-production and their attendant industries accounted for most unemployment. But these were layoffs, not long-term job loss. Builders, lumber mills, carpet mills, automakers and tire makers quickly recalled employees as soon as orders improved. Layoffs occurred when the Fed pulled back on the reins, and employees were quickly brought back as soon as the Fed let the reins dangle.

But the recent recession followed a different course. Low interest rates helped generate a residential-real-estate asset-bubble from 2002 through 2007. Since overall inflation remained low, the Fed did not pull back on the reins. Rising home prices encouraged, rather than discouraged, growing demand. Homes were an asset, not a perishable commodity. They could always be resold for a gain. Or so investors thought. The bubble burst in 2008 when home prices rose beyond any reasonable relationship to rents. Buyers stepped aside once home prices began to fall, and they have not returned.

The old horse and rider metaphor no longer applied. The Fed relaxed the reins until interest rates were in the basement. But the horse had run himself into exhaustion. He needed a rest, water and some oats, and It will be a while before the horse can run again. Since high interest rates and Fed restraint had not burst the bubble, low rates could not initiate rapid recovery. Household balance sheets remained in a state of disrepair: Shrunken asset values, inadequate liquidity and excess debt.

This time there will be no quick employee recall. Since the economy won't spring back, neither will employment. Those jobs have been lost for a long time.

That's why the economy will expand slowly and employment will gradually recover in 2012. Neither will improve rapidly.

© 2012 Michael B. Lehmann