Now in focus: Good times ahead

It won't be a zoom upward, but our financial problems have largely been righted.

The U.S. economy should have a break-out year in 2014. The path won't be straight up, and significant hurdles remain, but the economy's fundamentals are strong.

We have largely righted the economic wrongs that caused the Great Recession. Households that larded up on debt during the housing bubble a decade ago have gotten their finances back in order. The average share of after-tax income that households must devote to paying interest and principal on their debts is as low as it has been in more than 30 years.

The banking system has a big capital cushion and is overflowing with cheap sources of funds. Regulators now require the nation's largest banks to prepare themselves to withstand the darkest economic scenarios imaginable. With sturdy balance sheets, banks are looking to make a lot more loans.

Especially encouraging is the financial health of nonfinancial businesses. They've never been as profitable and competitive. If they survived the recession, they must be doing something very right; they either have a low cost structure or robust global demand for what they produce. The shale oil and gas boom, which ensures energy independence and lower prices, only adds to the positive story.

The main missing ingredient for stronger growth is confidence. The nightmare of the Great Recession has weighed heavily on the collective psyche, and political brinkmanship and policy uncertainty have been hard to bear. But sentiment has improved in the weeks since Congress agreed to reopen the government.

Investors are especially upbeat, as stock prices continue to hit record highs. Corporate credit spreads have tightened, as well, meaning that bond investors are demanding less of a risk premium to buy businesses' debt. Financial markets have been buoyed by the Federal Reserve's purchases of bonds, but investors also appear to expect better economic times ahead.

Consumers aren't as cheerful, particularly those in lower-income households that don't benefit from rising stock and house prices. Yet even here optimism is growing. Consumer sentiment falls each time federal lawmakers become embroiled in another budget battle. Encouragingly, however, confidence rebounded quickly after the latest standoff ended in October.

Businesses also appear to be getting their groove back. Responses to a weekly survey of business executives that Moody's Analytics has conducted for more than a decade have never been stronger. They are especially upbeat about their prospects at least through next summer. Other surveys of business sentiment aren't quite as strong, but they all indicate that corporate America is as enthusiastic as it has been since before the recession.

Not surprisingly, Washington remains the most serious threat to the budding optimism. That lawmakers recently struck a deal to fund the government and avoid another government shutdown during the next two years is a big plus. But they could still misstep over the current round of negotiations over the Treasury debt limit, which needs to be raised again by early next year when the Treasury's borrowing authority runs out. Not acting in a timely way would derail everything.

Stronger growth next year also depends on the Federal Reserve's ability to gracefully manage interest rates as the job market improves. This could be tricky; an undesirable surge in long-term rates last summer was triggered when Fed officials began merely to talk about winding down their aggressive actions. The jump in fixed mortgage rates hurt housing, which is vital to the broader economic recovery.

Policymakers have since worked to convince investors there are no plans to raise short-term rates soon. This appears to have worked, at least for now, as long-term rates are ending the year about where policymakers want them.

Economists have a tendency to forecast with a ruler, assuming the economy's recent performance will continue long into the future. Many such forecasts were issued in the last decade, assuming the good times would never end.

Similarly, straight-edge adherents now conclude that the difficult times seen since the recession are here to stay. This view holds that it will take years to return to full employment and that growth will be much slower than we want for the foreseeable future - that the economy is trapped in a so-called new normal.

Forecasting with a ruler is inevitably wrong, however, and this will become evident again in 2014. While the coming year could see another false start, the greater likelihood is that the U.S. recovery will finally evolve into a full-blown, self-sustaining expansion. The fundamentals are as good as they have been for decades, and it is increasingly difficult to envisage shocks that could undermine them.

Problems remain. A couple of million homes are still in or near foreclosure, and rapidly rising student loan debt is a concern. Europe also continues to struggle, and political tensions throughout Asia and the Middle East could boil over. But these threats don't feel as existential as those the economy has been grappling with in recent years.

Good times are at long last once again at hand. We are certainly due.


Mark Zandi is chief economist of Moody's Analytics. help@economy.com