You Decide: Are There “Excesses” Building in the Economy?

By Dr. Mike Walden

The word “excess” generally has a bad meaning in our society. It implies too much of a good thing that can lead to problems later. A second serving of my favorite apple pie can lead to an unwanted expansion of my waist line. Speeding to get to work on time can result in accidents and injuries.

There’s the same trouble with excesses in the economy. Recessions can result when some part of the economy develops excesses. At the time of the excess build-up everything looks good. Indeed, the buildup occurs when individuals and businesses are optimistic. But like extra pieces of pie that might burst my belt, too much of an economic buildup can lead to an implosion sending the economy into a tailspin.

Many commentators and analysts are already guessing about when the next recession will hit.   Here I look at four areas where excesses can develop, examine their current potential and then let you decide if we have reason to worry about an imminent economic downturn.

Stocks: After plunging during the 2007-2009 recession, the stock market has been on a roll, more than doubling since 2009. This has led to concerns that we are in an excess, or “bubble,” situation with the stock market that will ultimately bring a crash like in 1929 or 2008.

The standard measure to evaluate excess in the stock market is the price/earnings, or PE, ratio.   Here, “price” is the stock value, and “earnings” are company revenues after subtracting expenses. If the PE ratio sharply rises above a normal level, then the worry is the stock’s value cannot be supported by the company’s earnings and a drop in the stock value will have to occur.

Right now, most calculations of the PE ratio for all stocks suggest the measure is at the upper end of the historical normal range, yet still far below the heights reached prior to the two most recent recessions. So the PE ratio is flashing “warning – be watchful” but not “alert – get ready for crash!”

Home Prices: Home prices doubled from 2000 to 2006, plunged by one-third between 2006 and 2009, remained unchanged over the period 2009 to 2012 but since 2012 have posted an annual gain of 8 percent, well above the long-run average.

Is this reason for concern? Is another “housing bubble” developing? At this point most economists say no. It is not unusual for a market – like the housing market – to rebound sharply after years of declines or no gains. Also, construction of new homes has been slow as builders have been timid about returning to the market. So, the 8 percent annual price gains will likely moderate in the future. But if they don’t, then put housing in the “warning” category.

Debt:  Almost 100 years ago an economist named Irving Fisher warned of excessive accumulation of debt ultimately leading to an economic nosedive. Certainly the high debt loads carried by households in the 2000s were a factor behind the Great Recession.

The good news is that households and businesses have not returned to the debt binges they were on before the Great Recession. Growth in their debt has been modest, especially compared to the overall growth in the economy. Also, due to the drop in interest rates in recent years, interest payments on debt as a percent of disposable income is at a 30-year low.

Government – especially the federal government – has also benefited from the decline in interest rates for servicing public debt. But, unlike private debt, government debt has doubled since the start of the Great Recession. Some say this was a natural consequence of the steepest economic downturn since the 1930s.

The key driver for the impact of debt in the future will be the direction of interest rates. If rates rise significantly, then the burden of debt payments will jump and a possible slowdown in economic activity could result.

Money:  Since the start of the Great Recession, the ratio of money in the economy to national income has soared by almost 30 percent, prompting worries the dollar’s value will collapse, thereby sending the economy into a tailspin. Yet if a dollar crash was around the corner, we would expect to see inflation spike and the dollar’s international value sink – but neither has happened. One reason is the rate at which dollars change hands (termed “velocity”) has fallen almost exactly as much as the quantity of dollars has increased. This has effectively blunted the impact of the larger amount of dollars in circulation.

So what’s the “bottom line”? I see nothing at the moment pushing an “economic fall off the cliff.” However, each of the four factors deserve watching. In particular, if interest rates were to jump stocks could be hurt, home prices might slump, debt payments would rise and the effective size of the money supply would increase. Hence, it is understandable why the Federal Reserve has been so cautious about raising interest rates. But, as always, you decide!

Walden is a William Neal Reynolds Distinguished Professor and Extension Economist in the Department of Agricultural and Resource Economics at North Carolina State University who teaches and writes on personal finance, economic outlook, and public policy.