Happy New Year!

As 2007 comes to a close, many investors prepare to enter 2008 with some trepidation regarding the outlook on the economy.

Economists are widely quoted in the media predicting recession. Today's online Wall Street Journal features a video clip with the Chief Economist of Nomura Securities saying the economic activity in the first half of 2008 will be "flirting with recession" (although he goes on to predict that the second half will return to growth and that "we'll avoid a recession, although it will be a very close call").

Last week's InfoChoice Weekly Banking Bulletin (emailed weekly to subscribers in the banking industry in Australia and parts of Asia) led with a story entitled "Australia should be concerned about US economy" which cited former Morgan Stanley Chief Economist, now Morgan Stanley's Asia Chairman, Stephen Roach asserting that the US is heading into a recession in 2008 (this is not new: Mr. Roach has been predicting recession for some time).

Earlier that same week, economist and former Clinton Treasury Secretary and former President of Harvard University, Larry Summers, gave a speech entitled "Risks of Recession, Prospects for Policy" in which he stated that, "In my view it is almost certain that we are heading for a period of heavily constrained growth, quite likely that the economy will experience a recession as technically defined and distinctly possible that we are headed into a period of the worst economic performance since the stagflation of the late 1970s and the recessions of the early 1980s." Happy New Year, indeed! Not only does he throw around the R-word, but tosses in the 1970s and stagflation for good measure!

A constant barrage of predictions like these have investors in some doubt about welcoming in 2008, and have many scurrying for cover. Yet these predictions keep coming from the same sources that have been predicting the demise of the economy for seven years. They have been dead wrong!

As we have pointed out previously, we believe the current recession drumbeat is yet another false alarm, one reason being that recessions rarely arise when everyone is concerned about a recession but are much more likely when few expect a recession and businesses spend bullishly and mistakenly build up huge inventories. Or even more likely, recessions occur because of bad policy decisions, both monetary (too easy or too tight money) and/or fiscal (tax increases).

Further, as we have also discussed in earlier posts, many in the media and many economists have a demand-side mentality which attributes more weight to the consumer as the driver of the economy. This view has led to consistent underestimation of the strength of the economy for the past seven years. It also ascribes a greater ability of the housing sector to derail the rest of the economy than it has in reality. Almost all of the predictions of recession heard in the news predicate their recession predictions on spillovers from the housing sector.

However, housing only makes up 4.5% of the overall GDP. Even though that sector has been in serious contraction for several quarters, GDP growth has continued to be positive, indicating that the rest of the economy continues to post expansionary numbers in spite of the drag from housing. In fact, the third quarter GDP number (the most recent we have) came in at 4.9% after its final revision. In spite of the assertion of well known bond manager Bill Gross, who stated that we are already in a recession, some supply-side economists predict the current quarter's GDP growth will be above 2%.

The difference in these two views is that demand-side economists believe that housing woes will spill over to the rest of the economy because the consumer is disproportionately impacted by housing market fluctuations, while supply-side economists include the very real problems in the housing sector in their calculations but believe that the production of goods and services (more than 95% of which are not part of the housing sector) continues to grow.

They also point to the strong productivity numbers posted by the current economy. Earlier this month, Q3 productivity was revised upwards from 4.9% productivity growth to 6.3% productivity growth. As we have stated before, our decades of experience have shown that it is the production side (often called the "supply side") rather than the consumption side (or "demand side") that actually drives the economy, and supply-side economists have consistently been more accurate in their assessments of the economic growth than the more numerous demand-side economists (only about 15% of economists are supply-siders).

While the current and upcoming quarters will likely show slower growth than the exceptional third quarter, we believe that prospects for growth continue and that the current recession predictions are overblown.

The prospects for a happy 2008 are not as bleak as the news is making them out to be!

for later blog posts dealing with this same topic, see also:


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