Non-Manufacturing Data Not a Non-Factor

While manufacturing has staged an impressive rebound, the recovery in the nation's vast service sector has been more subdued. It also could prove more telling.


The Institute for Supply Management will release its index of February nonmanufacturing activity on Wednesday morning, and economists polled by Dow Jones expect it to rise slightly to 51 from 50.5 in January.

Such a gain would be encouraging, but it's a far cry from the improvement seen in manufacturing activity thus far. Since bottoming out in December 2008, ISM's manufacturing index reached a six-year high of 58.4 in January, a bullish sign despite its softening to 56.5 last month.

The factory sector's recent improvement has been bolstered by global demand for U.S. exports, inventory restocking and growth in business spending on equipment and software.

Factory activity may be on the mend, but it is a relatively small part of the U.S. economy, directly employing 11.5 million workers as of January, according to the Labor Department. Manufacturers have managed to increase their business through major productivity gains after cutting jobs deeply in the recession.

The service sector employs about 95 million workers but remains hamstrung by weakness in major industries like retail, finance, construction and transportation.

A similar effect was seen after the 2001 recession, says Brian Bethune, an economist at IHS Global Insight. Then, though, the red-hot housing market provided some offset.

This time around, Mr. Bethune points out, the housing market's collapse is one of the primary drags on service-sector activity. ISM's nonmanufacturing index has barely managed in recent months to stay above the 50 break-even level that signifies expansion. ISM's employment index looks even worse, stuck at 44.6 as of January.

To be sure, there is often a gap between pickups in manufacturing activity and pickups in broader demand for services. But an estimated nine months into the recovery, economists are getting impatient for signs of service-sector strength. If that doesn't materialize, risks mount that the recovery could lose momentum.

For that reason, investors who typically overlook the monthly nonmanufacturing report might want to start paying it closer heed.

I've been an optimist on China. But I'm starting to worry

--A macro strategy that exacerbate imbalance, in which the excession portion of stimulus went to fixed assetment investment and excessive bank loans was funnelled not to real economy but to inflat asset bubbles, is a receipe for doom --72% of stimulus went to fixed asset investment. bank lending in the first half is three times the pace of last year. Loan qualith suffered from the rash of disbursement in the first half. By Stephen Roach On the surface, China appears to be leading the world from recession to recovery. After coming to a virtual standstill in late 2008, at least as measured quarter-to-quarter, economic growth accelerated sharply in spring 2009. A back-of-the envelope calculation suggests China may have accounted for as much as 2 percentage points of annualised growth in inflation-adjusted world output in the second quarter of 2009. With contractions moderating elsewhere, China's rebound may have been enough in and of itself to allow global gross domestic product to eke out a small positive gain for the first time since last summer. That's the good news. The bad news is that China's recent growth spurt comes at a steep price. Fearful that its recent economic short- fall would deepen, Chinese policymakers have opted for quantity over quality in setting macro-strategy, the centrepiece of which is an enormous surge in infrastructure spending funded by a burst of bank lending. Sure, developing nations always need more infrastructure. But China has taken this to extremes. Infrastructure expenditure (including Sichuan earthquake reconstruction) accounts for fully 72 per cent of China's recently enacted Rmb4,000bn ($585bn) stimulus. The government urged the banks to step up and fund the package. And they did. In the first six months of 2009, bank loans totalled Rmb7,400bn - three times the pace in the first half of 2008 and the strongest six-month lending surge on record. This outsized bank-directed investment stimulus leaves little doubt as to how bad it was in China in late 2008 and early 2009. An unprecedented external demand shock, stemming from rare synchronous recessions in the developed world, devastated the export-led Chinese growth machine. That triggered sackings of more than 20m migrant workers in export-intensive Guangdong province. Long fixated on social stability, Beijing moved to arrest this deterioration. The government was determined to do whatever it took to restore rapid growth. Yet there can be no avoiding the destabilizing consequences of these actions. Surging investment accounted for an unprecedented 88 per cent of Chinese GDP growth in the first half of 2009 - double the average contribution of 43 per cent over the past decade. At the same time, the quality of Chinese bank lending most assuredly suffered from the rash of credit disbursements in the first half of this year - a trend that could sow the seeds for a new wave of non-performing bank loans. Just this week, Chinese regulators told banks that new loans must be used to bolster the real economy and not for speculation in equities and real estate. A little over two years ago, premier Wen Jiabao warned of a Chinese economy that was becoming increasingly "unstable, unbalanced, uncoordinated and ultimately unsustainable". Prescient words. Yet rather than act on those concerns by implementing a pro-consumption rebalancing, growth-hungry China was seduced by the boom in global trade and upped the ante on its most unbalanced sectors. By 2007, investment and exports accounted for about 80 per cent of Chinese GDP. And now, in the face of a severe global recession, China has compounded the very problems the premier warned of: aiming a massive liquidity-driven stimulus at its most unbalanced sector. This is not a sustainable outcome for any economy - or sustainable support for the world economy. China must redirect economic growth towards internal private consumption. This may require a compromise on the quantity dimension of its growth outcome. But to the extent that leads to improved quality in the Chinese economy, a short-term growth sacrifice is well worth the effort. Unlike most, I have been a steadfast optimist on China. Yet I am starting to worry. A macro strategy that exacerbates worrying imbalances is ultimately a recipe for failure. In many respects, that's what the global crisis and recession of 2008-09 are all about. China will not get special dispensation from the most critical lesson of this post-crisis era.

The Big Inflation Scare

PAUL KRUGMAN Suddenly it seems as if everyone is talking about inflation. Stern opinion pieces warn that hyperinflation is just around the corner. And markets may be heeding these warnings: Interest rates on long-term government bonds are up, with fear of future inflation one possible reason for the interest-rate spike. But does the big inflation scare make any sense? Basically, no — with one caveat I’ll get to later. And I suspect that the scare is at least partly about politics rather than economics. First things first. It’s important to realize that there’s no hint of inflationary pressures in the economy right now. Consumer prices are lower now than they were a year ago, and wage increases have stalled in the face of high unemployment. Deflation, not inflation, is the clear and present danger. So if prices aren’t rising, why the inflation worries? Some claim that the Federal Reserve is printing lots of money, which must be inflationary, while others claim that budget deficits will eventually force the U.S. government to inflate away its debt. The first story is just wrong. The second could be right, but isn’t. Now, it’s true that the Fed has taken unprecedented actions lately. More specifically, it has been buying lots of debt both from the government and from the private sector, and paying for these purchases by crediting banks with extra reserves. And in ordinary times, this would be highly inflationary: banks, flush with reserves, would increase loans, which would drive up demand, which would push up prices. But these aren’t ordinary times. Banks aren’t lending out their extra reserves. They’re just sitting on them — in effect, they’re sending the money right back to the Fed. So the Fed isn’t really printing money after all. Still, don’t such actions have to be inflationary sooner or later? No. The Bank of Japan, faced with economic difficulties not too different from those we face today, purchased debt on a huge scale between 1997 and 2003. What happened to consumer prices? They fell. All in all, much of the current inflation discussion calls to mind what happened during the early years of the Great Depression when many influential people were warning about inflation even as prices plunged. As the British economist Ralph Hawtrey wrote, “Fantastic fears of inflation were expressed. That was to cry, Fire, Fire in Noah’s Flood.” And he went on, “It is after depression and unemployment have subsided that inflation becomes dangerous.” Is there a risk that we’ll have inflation after the economy recovers? That’s the claim of those who look at projections that federal debt may rise to more than 100 percent of G.D.P. and say that America will eventually have to inflate away that debt — that is, drive up prices so that the real value of the debt is reduced. Such things have happened in the past. For example, France ultimately inflated away much of the debt it incurred while fighting World War I. But more modern examples are lacking. Over the past two decades, Belgium, Canada and, of course, Japan have all gone through episodes when debt exceeded 100 percent of G.D.P. And the United States itself emerged from World War II with debt exceeding 120 percent of G.D.P. In none of these cases did governments resort to inflation to resolve their problems. So is there any reason to think that inflation is coming? Some economists have argued for moderate inflation as a deliberate policy, as a way to encourage lending and reduce private debt burdens. I’m sympathetic to these arguments and made a similar case for Japan in the 1990s. But the case for inflation never made headway with Japanese policy makers then, and there’s no sign it’s getting traction with U.S. policy makers now. All of this raises the question: If inflation isn’t a real risk, why all the claims that it is? Well, as you may have noticed, economists sometimes disagree. And big disagreements are especially likely in weird times like the present, when many of the normal rules no longer apply. But it’s hard to escape the sense that the current inflation fear-mongering is partly political, coming largely from economists who had no problem with deficits caused by tax cuts but suddenly became fiscal scolds when the government started spending money to rescue the economy. And their goal seems to be to bully the Obama administration into abandoning those rescue efforts. Needless to say, the president should not let himself be bullied. The economy is still in deep trouble and needs continuing help. Yes, we have a long-run budget problem, and we need to start laying the groundwork for a long-run solution. But when it comes to inflation, the only thing we have to fear is inflation fear itself.