FIRST: THE ECONOMY

This Tunnel Has an End

Obsessed with negative economic scenarios? Don't be: 2003 may be the year the optimists finally get it right.

By Justin Fox

Ah, the things that could go wrong in 2003! A war in Iraq could backfire. Terrorists could strike in a big way. Housing prices could slump. Oil prices could skyrocket. America's overextended consumers could finally call it quits. And those are just the known risks. Other, unimagined plagues and disasters may lurk in the offing.

There's no denying it: Bad stuff could happen. But just as a blithe disregard for risk characterized the late 1990s, obsession with it seems to have taken hold in the early 2000s. That's too bad, because despite the scary talk, the most plausible economic scenario for the year ahead is one that should inspire not trepidation but modest optimism.

After two years of tough times and false dawns, the foundations have been laid for a solid recovery. Productivity growth is high, businesses have cleaned up their balance sheets, and there's little hint of inflation that might cause the Federal Reserve to slam on the monetary brakes. One of these days the U.S. economy is going to start firing on all cylinders again.

The consensus among economic forecasters is that this magic moment will arrive in the second half of the year. This is partly a bet that by summer the showdown over Iraq will have been resolved. It is also, as is the case with all forecasting, a guess. In reality we might have to wait until 2004 or 2005 before the economic news turns unambiguously positive. Or longer. It was more than five years after the 1990-91 recession had ended before everybody could agree that the U.S. economy was booming.

But even if we do have to wait awhile for clear signs of strength, the U.S. economy of the early 21st century has shown a remarkable capacity for muddling through. Despite unprecedented terrorist attacks, a stock market collapse, a sharp drop in business spending, and a wave of reality-based TV shows that decimated our collective IQ, the country got by with the mildest recession on record in 2001 and GDP growth of around 2.5% in 2002. In short, this economy has a way of making both the extreme optimists and the extreme pessimists look stupid.

The reason that optimists who predicted continued strong growth got it wrong is that amid the stock market euphoria of the late 1990s, corporations in America and around the world squandered hundreds of billions of dollars on investments--from software to factory equipment--that will never pay off. Many companies also borrowed heavily to pay for all that misspending.

But pessimistic predictions of an outright meltdown didn't come to pass either, because consumer spending barely missed a beat in 2001 and 2002. The huge, liquid markets for mortgages, auto loans, and credit card debt that grew up during the 1990s meant consumers didn't face the kind of "credit crunch" that shut down spending in past recessions. Instead, lower interest rates made housing more affordable and refinancing more attractive--and allowed automakers to offer 0% loans.

Which brings us to 2003. There's still a lot of unused fiber-optic cable out there, and a lot of factories operating below capacity. But U.S. corporations have mostly dug themselves out of their debt problems and are now capable of spending money if they see a need. A FORTUNE poll of CEOs indicates that many are finally in the mood to spend. That's no guarantee of a corporate boom, but the business sector should stop being a drag on the economy. Meanwhile, mortgage rates won't go much lower, and those 0% rates on car loans can't go lower. So consumer spending is likely to sputter in 2003, at least until businesses start hiring again. But even with the unemployment rate on the wrong side of 6%, spending won't collapse. Some cash from the 2002 refinancing boom is still in consumers' pockets, and tax cuts are on the way. There's also the weight of history: U.S. consumer spending hasn't gone backwards in a serious way (more than 1% in a year) since 1942.

Put it together, and you get a year in which parts of the economy do well, others struggle, and overall growth comes in between 2% and 4%. Sort of like 2002, that is. Except that in 2002, the economy had to cope with a wave of corporate scandals and a subsequent sickening stock market slide. Something else just as bad might happen in 2003. But if it doesn't, we may be surprised at how much goes right.