The first part of the year has presented lots of evidence that a good cyclical recovery is underway. Employers in numerous industries reported that they have started to hire again. One recent survey showed that job demand grew in 17 of 20 economic sectors and in 21 of 23 job categories. There is also evidence that consumer spending is increasing, at least in the luxury and higher end sectors. The recession probably ended sometime last summer, a few months after financial markets turned up, which is right in line with the historical average over the past 100 years.

At the same time, enormous legacy problems remain from the previous cycle and the response to the financial crisis. In the U.S., the federal and state governments face huge, open-ended fiscal deficits, unsustainable and unfunded promises made to future retirees, and high levels of unemployment. The situation is worse in Europe, where Greece, a member of the European Union and a participant in the Euro, has been forced to suffer the humiliation of a bailout by the International Monetary Fund (IMF). This is something generally reserved for bankrupt third world nations and shows that developed nations are subject to the same laws of economics as the rest of the world. (Some may recall that England received an IMF financing package in the early 1970s.)

It is easy to confuse the short-term positive outlook with the longer-term negative one, when in fact they aren’t inconsistent. The economic recovery reflects the normal cyclical characteristics of the global economy which have been observed for years. Companies over-invest and then retrench. Consumers overspend and then pay off debts. Markets shift from periods of optimism to pessimism and back. Each cycle is different, of course, and what clearly differentiates this cycle is that this recovery is taking place during a period where extremely serious long-term challenges with no obvious solutions linger. As Reinhart and Rogoff have pointed out in their excellent book, This Time is Different, history suggests that countries which incur huge debt levels generally end up defaulting on them in one way or another, either through non-repayment or through inflation. They provide ample and convincing evidence of this.

On the other hand, there have been cases where high debt levels haven’t led to this result. Following World War II, the United States had a debt to GDP level of 120%, higher than today and higher than that of Greece before its financial crisis.

Throughout the next generation, this debt level was paid down to more manageable levels. Similarly, in the late 1970s the U.S. experienced inflation of up to 13% and interest rates higher than that. A combination of a Republican president and a Democratic chairman of the Fed helped solve those problems. There are all sorts of reasons why those periods differ from the current one, but it still shows what could happen.

A mini industry has evolved to capitalize on negative economic thinking. Last week at the annual Milken Global Conference, a debate was held between Mike Milken and Nouriel Roubini. Roubini, a professor and former IMF economist who now has a successful consulting firm, has become one of the chief proponents of the negative long-term view. To his credit, he was one of the first to point out the evolving problems in the housing market, several years before they became apparent to most others. While that was a great call, he has remained very negative even in the face of evidence supporting a recovery. Roubini, who has a vampire like quality, has in our opinion a sort of caricature view of the U.S. which is common to many Europeans. This view holds that the U.S. is past its prime and lacks the political and economic will to face and overcome great challenges. While it’s certainly easy to see how someone could have this impression by reading the papers or watching cable television, the United States’ long-term track record of successfully addressing large problems shouldn’t be discounted.

On the other side, Milken proposed numerous solutions, some more practical than others, but always with an eye towards solving, rather than lamenting over policy challenges. On the practical side, Milken proposed some common sense changes to entitlements programs which would have a profound impact on the long-term outlook. On the more optimistic side, he points out that if Americans could get back to their average weight in 1960, the country could save $1.3 trillion per year in health care costs. For those interested, the debate can be viewed at (http:// www.milkeninstitute.org/events/gcprogram.taf?function=detai l&EvID=2122&eventid=GC10) the Milken Institute website.

The evidence that the economic recovery is underway is well documented. Financial markets have returned to value ranges which make security selection the key to good performance. Leadership in dealing with longer term structural issues will most likely come from the U.S.—hopefully soon.

William Andersen, CFA, Portfolio Manager,
Wanger Income and Growth Strategy and Principal,
Andersen Capital Management