Last Week's Highlights

The markets recovered this week, and seemed to calm down. Meanwhile, the economy continues to recover, albeit unevenly. Last week, there was a report that more than 200,000 new jobs opened up in the private sector. The Conference Board Employment Trends Index™ (a leading indicator of labor market activity) pointed to continued improvement over the next few months. Why then are initial claims for unemployment insurance remaining so stubbornly high? What is important to keep in mind is that some firms are still downsizing while others are adding more help. The recent change is that more firms are adding help, and the Employment Trends Index suggests this trend will continue. But there apparently has yet to be any cessation in those firms downsizing. It will be interesting to see if there is a change this summer. Such a change would signal that business is earning profits from current operations, not just from downsizing, despite the lack of pricing power and moderating productivity growth.

THE SITUATION ABROAD

The ink was barely dry on the nearly trillion dollar Greek bailout when the storm of criticism broke. Many criticized how long and how much it took to get an agreement at all. A deeper criticism focuses on the amount of borrowing needed to resolve a debt crisis. The longer-term worry is about the competitiveness of the Euro-zone, and perhaps even the sustainability of the euro. It was not that long ago that 1.5 euros were exchanged for one dollar. The market reaction to the debt crisis and its resolution has been to drive the exchange rate down to 1.25 euros per dollar - or about fair value on a purchasing parity basis. Will it stay there, or possibly go below fair value? The austerity programs might help restore some luster, but there are no guarantees.

FACT OF THE WEEK

6 percent. Spain's deficit problem is not as severe as that of Greece. So the austerity measures are not as draconian. Still, public sector employees will see their paychecks cut by 5 percent this year and again by 5 percent next year in order to bring the deficit down from 11 percent to 6 percent. E.U. members are required to — and most countries would like to — get the deficit down to the 3-to-4 percent range. By any measure, tough times are ahead, not just for Spain and Europe, and not just for the next year or two. Incidentally, the budget deficit to be closed this year and next amounts to about $11 billion. That compares with a deficit in California of $16 billion this year, on top of efforts already in place to close a $60 billion budget hole.

QUESTION OF THE WEEK

How big a role did global overcapacity play in the steepness of the recession? And how big a factor is it in deflation pressure going forward?

Overcapacity is being blamed for the run up in debt, public and private. The argument is that more supply than demand puts downward pressure on prices and therefore on revenues. Businesses went deeply into debt and some had to be bailed out from public revenue. Mounting debts played a role in widening credit spreads and freezing up credit.

If overcapacity remains a problem, then downward pressure on prices is a given. But a more fundamental question is how much overcapacity. Clearly in the depths of recession, supply exceeds demand. But is that a basic condition of the global economy now that global growth is returning to 4 percent (annualized)? The accompanying chart shows current and expected capacity to produce light vehicles across the globe. When compared to population (levels or percent changes), it would appear that overcapacity in general is not big a problem today nor expected to be over the near term.

In many sectors, demographic and economic changes will determine whether a problem develops, and therefore how big an impact it may have on prices in general. More importantly, therefore, the overcapacity argument is more about geography, and a potential mismatch between where the capacity is located in relation to where the goods are sold.