Proceed with Caution

After a number of false starts, the U.S. economy seemed to be gathering steam this summer. Consumer confidence was up. Home sales remianed robust. Business conditions were improving. And while joblessness continued to spread, the unemployment rate is often considered a lagging indicator. All of which seems to explain why the S&P 500 has staged such an impressive six-month rally—regaining more than a third of the value it lost after peaking in March 2000. Surely, most signs point to a sustained revival.

Not so fast, says Philip Arestis, a professor of economics at the Levy Economics Institute of Bard College, in Annandale-on-Hudson, New York. He, along with independent financial analyst Elias Karakitsos, recently authored a public-policy brief published by the institute, warning that "imbalances" in the private sector—chiefly soaring levels of personal debt—will limit the extent of any rally and put the U.S. economy at risk of a property-market crash and a double-dip recession (see "A Critical Imbalance" and "Can Stocks Outpace Income?" at the end of this article).

In the brief—"Asset and Debt Deflation in the United States: How Far Can Equity Prices Fall?"—the authors contend that the 2001 recession, though relatively mild, is part of a lengthier process of asset and debt deflation associated with the bursting of the telecommunications and Internet bubble of the 1990s. The imbalances created by that bubble, they contend, will continue to undermine any long-term economic recovery.

To be sure, lower interest rates have boosted the economy in the wake of the equities bubble. But, say Arestis and Karakitsos, they have also fueled a property-market bubble. And weak corporate profits, sustained primarily not by returns on new investment but by cost cutting, could force an overly indebted personal sector to curtail spending, sparking another, potentially more severe recession and perhaps a crash in the property market.

Unlikely? The authors see clear parallels between the economy's current imbalances and those produced by previous asset bubbles, including the depression of 1876 to 1890 (associated with the railway bubble), the depression of 1929 to 1940 (associated with the electricity and automotive bubble), and deflation in Japan that began in 1989 (associated with the electronics bubble). In fact, Arestis and Karakitsos say the current period has far more in common with those eras than with most post­World War II downturns, which were shorter and shallower, and typically followed increases in the prices of commodities, money, or both.

Disheartening as it may be, their conclusion—that we're in for a long period of painful retrenchment—deserves serious consideration, if only as a reality check on the glib, optimistic pronouncements emanating from parts of Wall Street and Washington, D.C. Arestis, who holds a PhD in economics from the University of Surrey in the United Kingdom, has authored a number of books and recently published work on such topics as monetary and fiscal policy and the relationship between finance and growth and development in such academic journals as the Cambridge Journal of Economics; the Eastern Economic Journal; the Economic Journal; Economic Inquiry; International Review of Applied Economics; the Journal of Money, Credit and Banking; and the Journal of Post-Keynesian Economics. He met with CFO deputy editor Ronald Fink in late August to discuss his outlook for the economy.

What makes you think the recent recession was more comparable to those associated with previous asset bubbles than to more-recent downturns reflecting the specter of inflation?
The [recent] economic downturn is not typical. It's not the kind of downturn we had in the '70s, for example. This is because of overinvestment in the late '90s, and that's very important. Most people would agree that there was New Economy thinking, in IT in particular, though we overinvested not just in telecommunications but in other areas as well.

And that the bursting of that bubble was not directly tied to a rise in interest rates?
No!

Your policy brief is quite pessimistic. Yet we've seen some very positive signs in the economy of late. What's the basis of your concern?
The private sector has taken on more debt, there's no question about that. [In fact], net wealth is decreasing to its more or less [historical] mean, or tending toward it. And while that might not appear so worrisome now, it could lead to a weak recovery or even a new recession in the future.

In terms of the personal and corporate sectors, we see these problems becoming reality, especially if unemployment increases further and disposable income goes down. In that case, the current huge increase in property prices becomes unsustainable. So we could very well have a property bubble as well. And if the corporate sector does not invest, its current imbalance of debt to income may very well continue.

But indications are that corporate profits are recovering. Isn't that cause for optimism?
The trend is driven by cost cutting. At the macro level, this means lower revenues for other businesses and lower income for consumers. One should also make the point that the recently enacted tax incentives on depreciation have had a major role to play. But then these are ephemeral. That is not a sustainable basis for recovery.

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