Bank of America Chief Economist: "No Recession in Sight"

12 Oct 2007

In a featured op-ed piece published in Tuesday's The Wall Street Journal, Bank of America chief economist Mickey Levy provided a thought-provoking and informative outlook on the United States economy, and articulated his view that despite some near-term challenges, the economy remains fundamentally sound and is unlikely to go into recession. The full text of his article is included below.

Levy also was a featured guest on CNBC's "Squawk Box" program Oct. 11, discussing his editorial.


No Recession in Sight

Despite recent financial turmoil and a dismal housing market, there are key reasons why the economy will continue to expand, albeit at a modest pace, and not go into recession. Businesses are well poised to absorb a period of weaker product demand and are unlikely to significantly alter their hiring and investment behavior. Consumer spending is supported by rising incomes. Exports are strong. And monetary policy is consistent with sustained growth in domestic demand. Next year, we will look back and once again marvel at the flexibility and resilience of the economy.

To be sure, there is bad news. Housing construction and prices will continue to fall at least through 2008. There is an 18-year high in the inventory of unsold homes and soft sales that are constrained by several factors, including expectations that home prices have further to fall.
The surge in home ownership, which rose dramatically to nearly 70% in 2005 from 64% in 1994, has proved just as unsustainable as the reliance on subprime mortgages. That surge has begun to recede, and lower prices and onerous adjustable-rate mortgage resets point toward a modest further decline — each one percentage point represents about one million homes. That decline, along with foreclosures, will elongate the housing inventory adjustment, exert downward pressure on prices, keep builders on the sidelines, and shrink employment in construction and the home finance sector.

The good news is that other factors will provide an offset. First is international trade.
Strong U.S. exports and less reliance on imports, reflecting healthy economies overseas and the weaker U.S. dollar, are boosting production and job creation here. During the housing boom years 2002-2005, residential construction added an average 0.4 percentage points per year to real GDP as the widening trade deficit subtracted 0.6 percent. That's now reversing. Since mid-2006, while the decline in residential construction has subtracted 0.9 percentage points from GDP growth, the narrowing trade deficit has added 0.5 percentage points. Expect more of the same.

Second, U.S. businesses are poised to withstand contraction.

During the late stages of prior economic expansions, as product demand slumped in response to excessive monetary restriction, firms tended to maintain production and employment growth, resulting in large inventory overhangs. Business capital spending also tended to grow too rapidly — witness the late 1990s investment boom. Consequently, most of the decline in real GDP during prior recessions was attributable to inventory liquidation, which meant cutbacks in production and jobs, and sharp reductions in capital spending. Presently, those conditions don't exist.

Businesses in a wide range of industries outside of the housing sector have nimbly adjusted their production processes, and inventories are very lean. That significantly reduces the potential impact of any slowdown in demand on production and employment. Similarly, firms have constrained investment spending while maintaining high cash balances. Following the capital spending boom of the 1990s, the unwinding of the capital stock, net of depreciation, also lowers the probability of a jarring reduction in business investment spending.

Third, Fed monetary policy points toward sustained growth in nominal spending. Despite the financial turmoil, credit remains available to basic businesses and the vast majority of households, and a general "credit crunch" is highly unlikely to unfold.

Historically, real disposable personal income has been the dominant factor driving consumer spending. As long as businesses maintain employment, and wages continue to rise, reflecting tight labor markets, rising personal income will outweigh the negative impacts of declining home prices, declines in mortgage refinancing, and even the recent increase in energy prices, on consumption.

This assessment presumes that businesses will not cut net jobs. No doubt, jobs will be lost in some industries — real estate, mortgage brokers and related finance, to name a few. But that's minor in the context of 138 million U.S. workers.

Fourth, my discussions with a wide array of business executives in an assortment of non-financial industries suggest that they have not materially altered their hiring plans, despite heightened concerns about general economic conditions. The majority plan to maintain employment levels or increase them in the next year, with most of the planned increases in export and international-related activities. September's reported rise in employment, covering the period of maximum financial crisis, is encouraging.

Once again, turmoil on Wall Street doesn't necessarily translate to contraction on Main Street.
Remember, following both the stock market crash of 1987 (which involved a cumulative 35% decline in equity valuations) and the 1998 financial crisis, the economy continued to expand. In both cases the Fed eased, financial markets absorbed the shock, and the economy proved resilient. The same will unfold this time; recession is not in the cards.