The Case for Economic Optimism

Practical Economics

The Case for Economic Optimism

Expectations have been lowered. The savings rate is up. Mortgage rates are at record lows. The stock market still has room to run. The next decade may turn out better than expected.

The daily economic headlines are depressing. But what I find really troubling is how dark the mood gets when the discussion turns to the longer term outlook. It's easy to see why. For example, the Congressional Budget Office projects the federal debt will reach 70% of gross domestic product by year end, the highest percentage since shortly after World War II.

SEE ALSO: Are You Better Off Than You Were Four Years Ago?

The widespread fear is that the combination of an aging population and pressures to embrace fiscal austerity will weigh heavily on the economy. Bill Gross, legendary bond investor and co-founder of the mutual fund giant Pimco, predicts the post World War II era of lush average annual stock market returns is over.

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Perhaps most disturbing is the gloom enveloping the prospects of recent colleges graduates. These are young adults that did the right thing by investing in their college education and graduating. Yet their wages in the aggregate have dropped 5.4% -- 1.6% for men and 8.5% for women -- between 2000 and 2011, according to the Economic Policy Institute. The combined unemployment-and-underemployment rate of young college graduates in 2010 and 2011 was 19.8% and 19.1%, respectively. Generation Debt is saddled with an unprecedented amount of student loans even as far too many have struggled to find work that doesn't require an expensive college degree.


But it doesn't take rose-colored glasses to see a more optimistic scenario, especially for young adults. Just look at the years after World War II.

Yes, caution is the generational watchword of the moment. Surveys show younger adults are wary of risks and disillusioned with the returns on homes and stocks. Yet the sobering memories of financial bets gone bad and the embrace of greater financial conservatism could eventually pay off big for those will to take a risk. Many American households are already laying the foundation for a stronger economy. "The generation coming out of the last decade, their expectations have been lowered," says James W. Paulsen, chief investment strategist at Wells Capital Management. "It's a good time to start out."

Learning from dad's experience

In other words, the younger generation could end up pleasantly surprised, much like young adults in the 1950s were. At the end of the Second World War, the consensus among opinion-shaping elites was that the U.S. was a mature economy destined to slide back into depression. The press wondered at the economy's strength and "almost everyone expected a crash, or at least a retrenchment, journalists had difficulty reckoning with month after month of continued economic expansion," writes Andrew Yarrow in The Big Postwar Story: Abundance and the Rise of Economic Journalism. With the benefit of historical hindsight we know the '50s economy grew at an inflation-adjusted average annual rate of 4.4%, despite three mild recessions.


The same story holds with investing. Memories of the devastating 1929 stock market crash lingered with a skeptical public as the Second World War ended. Professional investors fanned the flames of fear by constantly worrying that "another '29" lay ahead. Many Americans steered clear of stocks and sought refuge in safe fixed income securities instead.

After all, investors had earned a real 2% average annual return on their equity investments during the 1930s, compared to a real return of 7.1% on government bonds and 2.7% on short-term Treasuries, according to Ibbotson Associates, a division of Morningstar.

Yet intrepid equity investors sported a real average annual return of 16.8% on stocks during the decade of the '50s, while bondholders lost 2.2%, Ibbotson says. Treasury bills were down 0.3%.

Optimists were rewarded, like my parents. In 1949 they moved from an apartment in Queens with paper thin walls to Levittown, America's most famous postwar suburb. My parents were thrilled with their new home. It came with radiant heat, a refrigerator and a washer, a real step up in lifestyle for a family of three, soon to be four.


My grandfather was furious at his son for buying a home. He had bought a house in Yonkers, N.Y. in the 1920s. He lost the home during the Great Depression (thanks to an interest-only mortgage) and everyone in his extended Irish-Catholic family moved into a crowded two-bedroom rental not far away.

He never owned again. He believed my father was ruining his family's future by taking on a mortgage. But when I asked my mother why they bought after the experience of growing up in the Depression and World War II, she said they just believed times were going to get better. So did their neighbors. Without pushing the analogy too far, the sober '50s set the stage for the exuberant '60s, even though growth in the '60s came in at a fraction below the pace of the '50s.

A path out of debt

In the current environment, I think it's underappreciated how much progress households are making restoring their balance sheets. For instance, balances on credit cards in the second quarter of 2012 were 22.4 % below their peak in the fourth quarter of 2008, according to the Federal Reserve Bank of New York.


Similarly, the financial obligations ratio -- principal and interest payments on debt as well as other monthly expenses like leases and rental payments as a percent of disposable personal income -- reached an all-time high of 18.95% in 2007. The latest reading from the Federal Reserve for in 2012 has the ratio at 16.06%, about the same level as 1984. Americans are saving again. The personal savings rate is now at 4.2%, well above the low of 1 % reached in April, 2005. Taken altogether, household financial behavior is changing for the better.

Yes, student loan debt keeps growing. Institutions of higher education rely too much on students and their families borrowing to pay for their education. Nevertheless, despite the proliferation of truly horrific student loan debt stories, for a majority of college borrowers student loan debt is good debt, an investment in future earnings and careers.

Let's assume that over the next decade a healthier job market emerges. That's a reasonable assumption, based on what most economists of all political persuasions believe. Odds are the next five years will be better than the previous five years, thanks to improving household finances, a stronger housing market, and rising business investment.

The decline in housing prices has been miserable for existing homeowners, but the price plunge and low interest rates is a boon for young college graduates, newcomers to America, and other first-time home buyers. For example, the payment for a median-priced home with a conventional mortgage represents 12% of median-family income, the lowest percentage since records were kept starting in 1971, according to Fiserv-Case Shiller.

Homes aren't cheap, but with the ratio of median single-family home price to median family income lower than any time since 1991, prices are more reasonable. The same holds for stocks. Stocks have soared by some 110% since hitting a low in March, 2009. Nevertheless, the current valuation level of the stock market is not excessive with a current trailing 12-month price-earnings (PE) multiple slightly above 14 times. "Compared to past post-war stock market recoveries, the current valuation level of the U.S. stock market is only about average," says Paulsen.

And then there's the iPhone

One last glint of optimism: Consider the iPhone5. On September 17, Apple announced that pre-orders of its new smart phone topped two million in 24 hours, more than double its previous record of one million held by the previous iPhone. The iPhone embrace is emblematic of an economy where improvements in mobile technology, computer software, and information networks are rapidly gaining momentum. It suggests that today's techno-pessimists are underestimating the dynamism of mobile technologies and Big Data.

There are many different definitions of capitalism, yet in all its variations at its core capitalism is a system of continuous innovation. Combined with democracy, capitalism allows for what the late Herbert Stein emphasized as "the triumph of a society that, while retaining certain fundamental features, had adapted almost continuously, in one direction or another, to emerging problems, perceptions and theories."

That process is going on right now in millions of households across the country. Without minimizing America's deep-rooted problems like fiscal policy, the political environment, and widening income inequality, my best guess is that risk-takers in a risk-averse environment will be amply rewarded.