Is the economy a case of “chickens coming home to roost” to a double-dip recession and a possible deflationary cycle, or a several- year-long “slog” that forces us to accept the fact that slow-to-no growth is our new economic reality, the so-called “new normal”?

In other words, is the sky going to fall (again), as Chicken Little would have it, or are the Bluebirds of Happiness getting it right when they persist in chirping that we’re in recovery mode, albeit a slow one?
But first, how did we get into this mess?

Well, even though you’ve read or heard a thousand different takes on it, here’s my back of the napkin quickie as context for the rest of the article.

It was a result of a toxic combination of what Warren Buffet called Weapons of Mass Destruction, or derivatives leveraged to the moon (sliced and diced by the “masters of the universe,” spreading the risk around the world), along with a borrowing binge by consumers and our government against collateral that didn’t exist, or at most, was over-inflated, all to fuel massive over-consumption. Call it a “house of cards” or a “bubble.” Who cares? One collapsed, the other popped.

Then there was the short-lived ebullience, among many, late last year and into the first quarter of this year, over what seemed to be an emerging recovery. This enthusiasm began to fade, however, in the wake of a lot of negative second quarter economic data and discouraging third quarter forecasts, resulting in uncertainty over where the economy is headed. And uncertainty closes pocketbooks and shuts down business growth investment.

CLOSED POCKETBOOKS AND SIDELINED CAPITAL

GDP growth has proven to be a weak tailwind for these “birds.” From the robust 5% growth in the last quarter of 2009, with its hint of turnaround, it dropped to 3.7% in the first quarter of 2010, yet still offered hope for a sooner-than-later recovery (see Chart 1). Now second-quarter growth has been revised downward from 2.4% to under 1.6%, as we head into the third quarter, the all-important back-to-school season for retailers. And, while third-quarter GDP was originally estimated to grow by 3.3%, the most recent revisions have it at 2.3%, bringing back the doomsayers, speculating on the possibility of a “double dip” recession and even deflation at worst, or at best, years of clawing our way back to economic health. Contributing to the weakness in the GDP numbers is that inventory building, after many quarters of reduction during the downturn, represented a substantial 2.8% of the 5% growth in the last quarter of 2009, and 2.6% of the 3.7% GDP in the first quarter of 2010. For the second quarter it is just slightly over .6% of the 1.6% growth. On top of the re-stocking of inventory, which is now likely over, growth was also assisted by federal and state stimulus dollars, which are now being pulled back.

So, as we head into the last half of 2010, the fate of the economy is going to be left in the hands of consumers. And that is not a pretty picture. Unemployment is “sticky” at 9.5%, (see Chart 2). The University of Michigan Consumer Confidence Index is at a very weak 67.8. Housing prices and mortgage values are still under water. The National Association of Home Builders previously expected there would be 467,000 contracts for new home construction this year, but are now projecting 375,000, an almost 20% reduction. It’s not surprisingly therefore, that consumer spending growth was an anemic 1.4% in the second quarter, down from 1.9% in the first, and is on track to drop to 1.25% in the third. Consumers have been using their excess cash to pay down debt or increase savings. Household savings, on the other hand, increased to 6% of income, up from an average of 5.5% in the last three quarters. Consumer debt has been dropping for 20 consecutive months. Hey, you can’t have a buzzing U.S. economy, or even the beginnings of a recovery, when consumers, whose spending collectively represents 70% of GDP, are squirreling their money away, and worse, not binge-borrowing to support binge-buying. Speaking of which, spending could actually head further south when one considers the increase in personal bankruptcy filings. According to the American Bankruptcy Institute, personal bankruptcies increased from 598,000 cases in 2006 to over a million in 2008, a 77% increase. The figure is expected to rise to 1.6 million in 2010. Finally, and ironically, businesses are reporting record-breaking earnings.

Over two-thirds of the companies in the S&P 500 reported second quarter earnings that were at least 40% higher than a year ago, though sales were up only 9%. Much of the earnings gain was from cost-cutting, including layoffs. The bad news is that, unlike in the past, these companies are not rushing to use those earnings to build more capacity, hire workers back, or acquire new businesses until they can project a positive return of consumer demand and spending. This is the proverbial “what comes first, the chicken or egg” conundrum.

ROCKS AND HARD SPOTS AND NOWHERE TO HIDE

And, if you think you just read the whole script, not so fast. It’s not over until the “fat hen sings,” in keeping with the metaphor, and boy have we got more.
Adding to the angst of uncertainty, who really understands what impact all the new financial regulations will have? First off, how many new government “regulators” will police the industry, at taxpayer expense? And, how big an army of new regulation specialists will the financial firms need to hire to analyze and implement the regulations? I hear thousands on both sides. The good news: new jobs. The bad news: more “non-rain-making” bureaucrats. How will new capital requirements impact lending and investing? What will be the effect of new transparency requirements on positive risk-taking? And how on earth do these firms replace the billions of dollars of revenue from trading and hedge fund businesses they will be forced to shed?
And, at the end of the day, as “all ships” in the financial industry are lowered, there will no doubt be less capital for lending to Main Street, i.e., consumers and small businesses. Since small businesses are responsible for an estimated 60% of new job creation, and consumers 70% of GDP, this does not make for smooth sailing. Oh, and what about lower ships equal lower tax revenues for federal, state and local governments?

WHAT A TRAIN WRECK WAITING TO HAPPEN. BUT, THAT’S NOT ALL FOLKS.

Even more non-value-creating bureaucrat jobs will be created in human resources departments across all industries to make sense of and calculate the costs of the recently passed health-care overhaul. Better those functionaries poring over 2000-plus pages than me! And, what happens if they find more costs in those pages? Does it lead to more cost-cutting in other areas of the business, such as more job cuts, or higher prices, or both? Call it a “house of cards” or a “bubble.” who cares? One collapsed, the other popped.

Of course, we are all waiting for the decision of whether or not The Bush Administration’s tax cuts on personal income, dividends and capital gains, due to expire in January, will be extended. What effect will that decision have on consumer spending?

Last, but by no means least, are the truly scary murmurings of a VAT (value-added tax), or a tax that is applied to each step in the supply chain where value is added, starting with the ingredient product, then the manufacturing process, and, finally the finished product at retail. Regardless of the complexities and issues surrounding the debate, two things are for certain: a portion of this tax is added on to, and, therefore raises the final sales price; and, its enactment is probably not a question of if, but, when. Most countries in the industrialized world have VATs, why not us?

Well, all I can say is that this had better be one of those “cans they kick down the road.” Talk about shooting a sputtering economy in the head!
We can turn to Japan for that lesson. (See Japan sidebar)

DEFLATION WITHOUT TAXATION?

Is it possible we could experience deflation without such taxation?

On the supply side sits the match that can light the deflation fire: according to a recent Nomura Securities report; “the U.S. economy continues to operate with a staggering amount of spare capacity – unemployed workers, idle trucks and factories, etc.”

Jan Hatzius, Chief Economist at Goldman Sachs (GS), agrees. In an August 6 Wall Street Journal article, he said that this kind of extra capacity impedes companies from raising prices, and therefore increases the risk of deflation. “The prospect of substantial inflation seems very remote, but the prospect for deflation is far from remote. A double dip is certainly possible, but not likely.” Hatzius also said “It’s plain to see there’s a ton of slack in the economy. We’re not managing to generate enough demand to absorb all these productive resources in the economy.”

On top of his Goldman Sachs credentials, Hatzius snagged the top spot in a recent ranking of Wall Street economists, and has been honored for his ‘uncanny’ economic forecasting that anticipated the global financial crisis. His dire view is based on the fact that, not only has there been a slowdown in consumer spending, consumers are using their remaining cash to add to their savings, which was 6.4% of income in June compared to pre-recession levels of 1% – 2%, and to pay down debt, which has been dropping for 20 consecutive months.

Looking ahead into 2011, Hatzius revised his GDP estimate from 2.4% down to 1.9%. He also projected unemployment to hit 10% in the second quarter of next year.

Just to toss another heavyweight’s opinion into the ring, Bill Goss, who heads up the $239 billion Pimco Total Return Fund, was quoted in another WSJ article last month: “deflation isn’t just a topic of intellectual curiosity, it’s happening,” citing an annualized 0.1% decline over two years in the consumer-price index. “It’s an uncertain world that’s tipping toward deflation.”

And, a final and serious conundrum for retailers, and one which further complicates the deflation issue, is the fact that China’s manufacturing sector, where many of the products we consume are produced, has been pressured by workers to increase wages, which is happening. Ingredient product prices and transportation cost are volatile, with severe upward pressure. As these increasing costs are passed along to retailers, are they going to be able to pass them on to consumers, when consumers will be expecting lower prices? Who will blink first, retailers or consumers? You know my answer.

LOTS OF QUESTIONS – FEW ANSWERS

As of this writing, there are many more questions than answers regarding what consumers, businesses, and the government will or can do to clean up this unprecedented economic mess.

Will consumers crawl deeper under the covers and stuff more of their money under the mattress? Will they continue to spend, however frugally? And, what in the world is our largely dysfunctional government going to do about our unprecedented debt level? Having used up the conventional tools of lowering interest rates and fiscal stimulus, the Fed and Administration are running out of options. Do they dare cut spending, increase taxes (or both) in an economy that’s on the edge of another “dip,” and possibly even deflation? Remember, this is a mid-term election year! Do they attempt another stimulus plan, piling on more debt, when the first one did more propping up than stimulating? Do they cut taxes?

Are cash-fat businesses going to invest in growth, build more capacity, hire more workers? Will banks ease lending to stimulate small business growth or easier credit for consumers, all when uncertainty reigns about how much demand is going to return in the marketplace, and what our government intends to do on all fronts? “Chicken Little,” indeed, and it seems as though the Bluebird’s chirping grows weaker and weaker. Perhaps it’s the other end of the bluebird that will be dropping something on our heads as he flies over. I hope not.