The Economy in 2011 and Beyond: Bright Spots Amid Dark Clouds

In 2011, slow job growth and high unemployment headlined each month’s employment report. Is the economy likely to do better in 2012? There are some economic bright spots that suggest the economy’s internal dynamics are quickening. But there are also serious outside risks that challenge policy makers both here and abroad: The unresolved debt crisis in Europe, the slowdown in China, and as of this writing, the U.S. fiscal tightening that will occur if there is another policy stalemate.

For the past four months, employment measured in the survey of households has averaged around 300,00 a month, well above the trend growth rate of the working age population and enough to reduce unemployment meaningfully. This far exceeded the employment gains measured from the payroll data of business establishments which are the ones headlined each month. Slow employment growth has been holding down incomes and consumer demand, helping perpetuate the weak expansion. If recent months are a guide, that drag on expansion may be over. But demand from other sectors will have grow, and the prospects for that are mixed.

The construction sector spans a broad range of activities from residential improvements to bridge building. Over the past year, declines in public construction, driven by the drop in state and local revenues, about offset the increases in private construction where a big upswing got underway in nonresidential building. Construction rose by between 10 and 20 percent in the commercial, recreational, power, manufacturing and transportation areas. There is reason to expect strong gains again in 2012 since corporate internal funds are plentiful and borrowing conditions remain easy. Furthermore, the pressure on public sector spending should ease because state and local budgets are in better shape than they were a year ago.

Homebuilding is a different matter. The historic excesses of the housing sector continued to hold back the U.S. expansion in 2011, and they still dominate housing prospects for 2012. In the aggregate, house prices are down nearly a third from their 2006 peaks and the fraction of mortgages that are under water is still at historic levels. If there is a bright spot in this picture it is that housing markets are local. Normally these local markets are highly correlated because they are driven by aggregate developments such as borrowing costs and the rise in wealth and incomes. But at present, local markets are driven by earlier price excesses, and these were far worse in some areas than others.

House prices have stopped falling in most of the country and have started rising in some areas. High end Manhattan real estate bottomed some time ago. Prices in the upper East Side and Upper West side are up 10 percent over the past year and major new construction projects are in the works. In south Florida, the lower end of the market continues to be severely depressed but sales of higher priced condos in the Miami area are recovering, thanks mainly to an influx of buyers from Brazil and other prospering Latin countries.

Lower cost areas will be the slowest to recover, both because they were particularly hard hit by mortgage problems and because they are the most affected by the present job market. But more building of any sort will help employment in construction and in related industries such as building materials and home furnishings. During its period of steep decline, residential construction directly subtracted about a percentage point from GDP growth. It is too early to expect a substantial positive contribution this year. But at least the decline is over and some recovery is underway.

Exports, which are highly responsive to growth rates in other economies, have been a bright spot from the start of the present expansion . Even over the past year, when global growth slowed markedly, they contributed nearly a percentage point to the disappointing U.S. growth rate. But the immediate future for export demand is quite uncertain. Europe’s expansion is in jeopardy, and Chinese growth has slowed markedly.

China has become a major market for U.S. exports of raw materials and capital goods, and their growth importantly affects other Pacific rim economies. So how well China manages its current slowdown is key. As in other countries, a construction boom is at the center of the slowdown, but parallels end there. Chinese banks are instruments of state policy. So bad debt problems and overbuilding should not get in the way of restoring economic growth. But for the immediate future, China’s demand for our imports will slow.

Europe poses a greater risk. The December summit meeting in Brussels did little to address the problems of the euro system for the long run and provided only ambiguous guidance for the near term. A very hopeful interpretation is that Germany will accept whatever degree of ECB support the Sovereign bond markets need. If that is not forthcoming, the range of bad outcomes for Europe and for its trading partners is very broad.