The U.S. economy is expected to advance at a moderate rate in 2012, but Europe presents a key downside risk to the outlook. That aside, there are longer-term uncertainties about potential growth over the next several years. Next year will be an election year and income inequality could be an issue.

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Weekly Commentary by Dr. Scott Brown
Some Questions For 2012 And Beyond
December 19 – 23, 2011
The U.S. economy is expected to advance at a moderate rate in 2012, but Europe presents a key downside
risk to the outlook. That aside, there are longer-term uncertainties about potential growth over the next
several years. Next year will be an election year and income inequality could be an issue.
Like any good horror movie, the European crisis has carried an ongoing feeling of dread. The potential for a
catastrophic collapse is palpable. For the U.S., a meltdown would hit exports, but the bigger fear is possible
financial market disruptions. U.S. banks may have a limited exposure to European sovereign debt, but they
do have significant exposure to the big European banks. We could see a seizing up in the global financial
system, much like we saw in the fall of 2008. However, the Fed and other central banks have foamed the
runway, adding liquidity ahead of possible crash or rough landing.

2. For the most part, the prescribed medicine in Europe has not helped the patients. Austerity is contractionary
policy, best employed in booms, not busts. Growth is the central issue here. More importantly, the
governments in Europe will be unable to provide a large enough backstop if Italy were to leave the euro zone.
The markets sense that, and without a lender of last resort, the crisis may be self-fulfilling. The ECB has
rejected a role as the ultimate backstop of European debt, but it will likely be drawn in eventually as push
comes to shove.
What about the U.S.? How long until we get a full economic recovery? It’s important to remember that this is
not your father’s recession. It is your grandfather’s depression. There is no precise definition of a depression
(note also that a recession is largely a judgment call). Most economists would say that a depression is an
extended period of elevated unemployment. That suggests roughly where we are now.
Over the last several decades, real GDP growth has averaged about 3% per year. We are about 12.6% below
that trend now. However, there may be some reasons why the trend may be lower in the years ahead. In the
1970s and 1980s, the U.S. experienced an increase in female labor force participation. That trend has played
itself out, and both male and female participation rates may be expected to trend lower as the baby-boom
generation moves into retirement. As a consequence, unless productivity growth picks up substantially, GDP
growth is likely to trend somewhat slower in the years ahead.
The shares of national income going to corporate profits and labor tend to move in opposite directions over
the course of the business cycle. However, since the early 1980s, the underlying trend has been more to
profits and less to labor. Part of this can be explained by the steady decline in union membership and by
increased low-wage labor competition from abroad.

3. Economists tend to shy away from questions about income inequality. It’s not clear whether moderate shifts
in the distribution of income have much influence on overall economic growth or what should be done about
it. For the most part, these are political issues, not economic ones. However, political issues often have
implications for investors. While many have been quick to dismiss the Occupy Wall Street protests (the drum
circles and lack of clear goals haven’t helped the cause), this bears watching closely. We’ve had a number of
populist movements in our history. More often than not, they run out of steam, but sometimes they turn into
a more significant political force. However, it seems doubtful that we’ll have a viable third party candidate in
2012. The question then is whether the Democrats can shed the mantle of “Republican-Lite” and embrace the
OWS movement. Or perhaps the Republicans can motivate the Tea Partiers to go to the polls in force.
Whatever the case, it’s going to be an interesting year.