By Richard W. Fisher

The following are excerpts from a speech delivered by Richard W. Fisher at the Laboratory for Aggregate Economics and Finance University of California, Santa Barbara on September 3, 2009.

(Caijing.com.cn) In explaining how the economy will transition from recession to recovery, we at the Dallas Fed have been referring lately to "the Johnny Mercer effect," after the Hollywood lyricist who penned the refrain "Ac-cent-chuate the positive [and] e-lim-i-nate the negative."

Here is how it works. Residential investment, inventory investment and consumer spending together account for 3 percentage points of the 3.9-percentage-point decline in real gross domestic product (GDP) that we've seen over the past four quarters. So, if we eliminate these negatives, we go a long way toward stabilizing the economy.

The latest monthly indicators suggest that the drag from residential investment has stopped. Indeed, our latest estimate is that residential investment will add roughly half of 1 percentage point to GDP growth in the current quarter. Inventory investment is likely to remain negative, but as long as it does not become even more negative, it will cease to be a drag on GDP growth. And if the pace of inventory liquidation moderates, you eliminate a powerful negative and begin to accentuate the positive.

Consumption, the most prominent of all GDP components, has suffered its biggest four-quarter drop since 1951. But, as Milton Friedman taught us, households adjust their spending levels quickly as the economic outlook changes, without waiting for the changes to be realized. In other words, they cut their spending as job prospects deteriorate rather than wait for layoffs to actually occur. This means that the worst may well be over for household consumption, barring some new shock. We certainly do not expect American consumers to come surging back to fuel a global boom any time soon, but the latest data on personal consumption expenditures (PCE) and retail sales are broadly consistent with Friedman's theory. Real household spending rose for the third month in a row in July and is up 0.6 percent (not annualized) so far this year, though some of this growth undoubtedly reflects the cash-for-clunkers program, which has now expired.

In a similar vein, the latest report from the Institute for Supply Management shows export orders swinging into positive territory as the economies of our overseas trading partners begin to turn around. Again, we have a reversal of signs and the elimination of a negative: Falling exports subtracted 1.9 percentage points from GDP growth over the past four quarters. Nonresidential fixed investment has been an even larger drag on the economy, subtracting 2.4 percentage points from GDP growth. But, as with consumption, the latest monthly indicators suggest a bottoming out and hint at the beginnings of a modest expansion.

Meanwhile, government stimulus spending is kicking into gear, accentuating a positive: Government purchases added 1.3 percentage points to GDP growth last quarter, up almost 1 percentage point from the average of the previous three quarters.

The point is: A lot of former negatives are being eliminated or even turned into positives. Former positives, like government purchases, are being accentuated. The combination is beginning to propel the economy upward.

The question is: How robust and sustainable will the recovery be?

Inventory adjustments, while welcome, are of temporary utility. Any boost to growth we receive as firms achieve control of their inventories will be the result of a rebalancing of supply and demand that is inherently transitory. Sustained growth will have to come from somewhere else.

I doubt it will come from housing or a return to the bad old days of financial Bacchanalia. We do not want—and cannot expect—massive foreign capital inflows or domestic investment indifferent to risk to finance another boom in household spending and residential investment. That means we will need to see a massive reallocation of capital and labor away from such formerly hot growth areas as construction and finance. This reallocation will be impeded by financial markets that—while improving—continue to operate at less-than-full efficiency. I surmise that the re-gearing will take time and that, in the interim, households and businesses will focus on shoring up their savings and balance sheets rather than spending money. For consumption, that translates into a slow crawl out of purgatory. For capital expenditures and employment rolls, it means an emphasis on tight budgeting and a continued focus on absolute needs rather than wants.

For the past four years, I have personally surveyed 30 or more chief executives of key companies in a broad array of sectors before every Federal Open Market Committee meeting to get a read on how they are positioning their enterprises.

These operators of our economy—private-sector operators whose teams decide what to purchase, what to produce and how many workers are needed to turn inputs into products and sales—are still suffering from shock induced by the trauma of the crisis. I would say they are suffering from "post-traumatic slack syndrome."

Until the summer of last year, businesses were emboldened by a prolonged period of ready money and robust global demand. They were geared toward the expansion of plants, equipment and payrolls. At the same time, inflationary pressures were building. Businesses took every measure possible to boost their top lines by passing on rising costs through higher prices. As we entered the summer of 2008, the inflation data exhibited frightful tendencies. Of the 178 items in the consumer's basket used to measure PCE, 77 percent were rising, and the number rising above 3 percent per annum was the highest we had seen in nearly two decades.

There are limits to the costs that can reasonably be passed on to consumers without damaging top-line revenue performance. Thus, simultaneously, businesses worked like beavers to preserve their bottom lines by controlling the costs of goods and services they sold, shifting their management models and budgeting accordingly.

Then they experienced a traumatic shock. Demand imploded. The equity and fixed-income markets seized up. Bank credit evaporated. The growth of the global economy hit a wall. Whereas just over a year ago managers were coping with a pervasive scarcity of inputs and escalating prices, there is now an abundance of almost every input and output and no pricing power. There are too many ships at sea; too many rail cars; too many airplanes and trucks; too many homes; too many hotels and apartments and office buildings; too many retail stores and malls and convenience stores; too much oil, natural gas and corn; and, according to Wall Street Journal reports this week, even too much champagne and bottled water.

And yes, thank you Lord, we have finally come to realize there are too many lawyers.

In almost every sector of the economy—save for non-elective medical services and a few basic commodities being hoarded by the Chinese—the CEOs I survey are struggling to cope with excess capacity and slack.

Businesses trying to sell products and services feel they are pushing on a string and are adjusting their behavior accordingly. To maintain sales volumes and clear inventories in the face of weakened demand, they are cutting prices. Beginning in the fourth quarter of last year, we began to see an upward shift in the number of items falling, rather than rising, in price. In the July data just released, almost 50 percent of the items in the PCE basket—weighted either by simple count or expenditure—were falling in price. Small wonder that headline inflation was negative over the year ended in June: This is the first time since 1955 that we have seen deflation.

And top lines have evaporated. In this most recent quarter, for example, the 376 non-financial companies in the S&P 500 reported a nearly 20 percent decline in top-line revenues. This is the third sales decline in a row—the first time we have seen this since 1965.

Evaluating the Numbers

The new numbers tell me two things. First, for the immediate future, the risk to price stability is a deflationary risk, not an inflationary one. And second, given they are operating in the shadow of the absence of pricing power and the pervasive difficulty of expanding top-line revenues in the face of weak demand, businesses will continue to run tight budgets as they try to preserve profit margins. They will continue to focus on cost control, most painfully by shedding workers and driving those who remain on the payroll to higher levels of productivity.

All of which means that we are likely to see a prolonged period of sluggish economic performance and uncomfortably high unemployment as businesses reallocate capital and labor to fit the new economic landscape.

The needed reallocation of labor and capital has been, and will continue to be, impeded by financial markets. Although substantially improved from last fall—due in significant part, I would argue, to the work of the Federal Reserve—markets are still a long way from having normalized. We know from our own experience and from the experience of other countries that financial headwinds like these take years to abate.

To offset those headwinds, fiscal authorities have stepped forcefully into the breach, putting in place a massive stimulus effort. They have done so with the intent of limiting the damage to disposable income from unprecedented declines in wage and salary income—while trying to goose up capital expenditures on infrastructure.

If you go back to the rudimentary formula taught in high school economics to account for the makeup of GDP—consumption plus investment plus government expenditures plus net exports—the "G," or government, variable is receiving enormous emphasis, while "C" is flaccid, "I" is hesitant and net "X" is tentative. At the present rate, federal, state and local authorities are expected to spend, net of intra-governmental transfers, $5.4 trillion in 2009—just under 40 percent of expected GDP.

The problem is that government stabilization measures come with a real long-term price tag: higher tax rates, greater national indebtedness and the prospect of higher interest rates driven by the government's issuance of debt. These long-term costs of a larger government limit the American people's willingness to rely on the public sector to drive overall economic growth. A fiscal gag reflex ensues, and the public-sector option looks less and less attractive as anything other than a temporary source of growth.

The major challenge facing U.S. fiscal authorities is meeting the need for near-term economic stimulus while pursuing a practicable plan to stabilize the government's debt-finance obligations. The Secretary of the Treasury is doing his level best to reassure investors—both overseas and here at home—that the programs put in place by the Obama administration will work their magic and then be gradually withdrawn as the economy gets back into stride. But this is no simple task. It is now common knowledge that deficits are growing at $3 million per minute and will accumulate to some $9.1 trillion over the next decade. And our fiscal predicament is compounded by the embedded unfunded liabilities of Social Security and Medicare. By our calculation at the Federal Reserve Bank of Dallas, the present value of the unfunded debt of these two entitlement programs has reached $104 trillion, with $88.9 trillion of that due to Medicare alone.

The legendary actor Errol Flynn is reported to have quipped that his problem lay in "reconciling [his] gross habits with [his] net income." I imagine the American public and its representatives are close to their limit of tolerance of the "gross habits" of government and the net new indebtedness they are willing to pass on to their children, all of which suggests that, as an antidote to what ails the economy, government spending is a thin reed on which to rely. Given the expected slow adjustment rate of the other components of final demand, my guess is it will be a long time before we see growth strong enough and sustained enough to make an appreciable dent in excess capacity. I envision an output path going forward from here that looks something like a check mark, with the Johnny Mercer effect giving us a near-term snapback from the short, intense downstroke, followed by a transition to a long period of slower growth corresponding to the elongated side of the mark.

Richard W. Fisher is president and CEO of the Federal Reserve Bank of Dallas.

All opinions expressed in this blog are those of the author alone and do not necessarily reflect the views of Caijing Magazine.