Economic optimism for 2011 was a bit early but not misplaced

Looking back at my economic outlook for 2011 in The Inquirer, I was clearly too optimistic. I expected better this year; while the U.S. economy grew, it did not expand enough to make anyone feel very positive.

Why was I wrong? For one thing, I didn't anticipate that gasoline prices would surge to $4 a gallon. The Japanese earthquake was another unexpected setback. But what really derailed the forecast was the shocking political acrimony in Washington that culminated in a near-default on the nation's Treasury debt last August.

Unfortunately, the economy in 2012 continues to depend on what policymakers do, in Europe as well as in Washington. A seemingly interminable debt crisis has pushed Europe into recession, with growing repercussions for the United States. Stock prices have gone essentially nowhere since Europe's problems emerged nearly two years ago. Financial systems on both sides of the Atlantic face pressure that is sure to impair the availability of credit. A European recession would also weaken global trade.

Europe's downturn is expected to be mild, lasting through the middle of 2012 - but only if policymakers can quickly stabilize financial markets. It is encouraging that the European Central Bank has teamed up with the Federal Reserve and other key central banks to provide cheap funds to the stressed banking system. The ECB is also providing longer-term financing and easing collateral requirements for European banks seeking loans. This is a welcome signal to financial markets that monetary policymakers will not allow a major bank to fail because of lack of liquidity.

Financial markets should also be cheered by the increasing commitment of European governments to fiscal discipline. The most profligate nations have voted in new leaders who appear to be implementing serious austerity programs. Collectively, European Union governments have agreed to stiffer fiscal rules, more stringent oversight, and harsher penalties if the rules are broken. Officials also say they will enlarge the European bailout fund and the International Monetary Fund to help fiscally troubled governments. This should allow the ECB to continue buying enough debt to keep these governments' borrowing costs from spiraling out of control.

Despite all these efforts, it remains easy to construct dark scenarios in which Europe loses the political will to keep the eurozone together in its current form, and its economy enters a deep downturn. That would cause the U.S. economy to sink as well.

U.S. performance next year also depends on what Congress and the administration do, most immediately about the reduced payroll-tax rate and expanded unemployment insurance benefits. These are expensive programs, but not extending them could be even more costly to taxpayers if the economy slips back into recession - a significant threat, particularly early in 2012. If payroll taxes rise and unemployment benefits are cut, the effects will peak just as the economy struggles with fallout from the European debt crisis.

Given the heightened political and policy uncertainty, it is hard to see businesses expanding operations, increasing investment, or hiring more aggressively soon. Firms have the financial wherewithal to do so - profits are strong, and balance sheets are sturdy - but managers still seem shell-shocked from the effects of the Great Recession and discombobulated by events in Washington.

Historically, economic recoveries have evolved into self-sustaining economic expansions when businesses took the leap and expanded without knowing for sure whether demand justified the additional production. When managers could no longer increase profits and support their stock values by cutting costs, they took a chance. Better profits and healthier finances fueled expansion as they sought new revenue opportunities.

The current business cycle appeared to be following this pattern when I wrote my Inquirer piece a year ago, as firms began investing and hiring more robustly. But this positive dynamic was short-circuited by the surge in oil prices, the Japanese disaster, and the spectacle in Washington. The economy was not thrown back into recession - although it came close in recent months - but the turn to a self-sustaining expansion was delayed.

How long it will take to get the business cycle back into gear isn't yet apparent, but it seems unlikely to happen until after the election in November. I don't expect 2012 to be a breakout year for the economy. Perhaps the elections and the accompanying debate will spur businesses to get back in the groove.

Yet while the recovery may not gain much traction in coming months, the U.S. economy's ability to hold up in the face of adverse shocks testifies to its resilience. It also suggests that the economy is righting the wrongs that caused the Great Recession and slowed the subsequent recovery. While more work needs to be done, the private sector has rapidly reduced its debt burden. The public debt load is still rising, but if Congress and the administration stick roughly to what is in current law, that too will stabilize soon.

The coming year may not be all one might hope, but the economy is shaping up to exceed expectations by mid-decade. My optimism last year was premature, but it wasn't misplaced.