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The economic recovery began in July 2009. Since then we have been plagued by a plethora of good economic news and not-so-good economic news. David Wessel, in the Wall Street Journal, captures this continuing saga in “An Economy Poised Between Flight and Fright.”

It has become obvious to many that the current experience is not that of a conventional business cycle. The economy is recovering but the pace is extremely slow and the fragility of the recovery is obvious to almost everyone.

Major focus has centered on the banking system, the housing and the household sectors, and labor markets. These worries translate into issues of solvency and deleveraging.

On top of this is the tension over Iran, Syria, Afghanistan, the rising price of oil, and the financial difficulties of the eurozone.

The important thing, to me, is that the economy is recovering. The second most important is that the major problem areas the world is facing have been identified. Given these two factors, the major policy issue faced by the monetary authorities…and the fiscal authorities…is to avoid further unexpected shocks to the system.

For one, the Federal Reserve is dealing with a very fragile banking system. Last year, 240 commercial banks left the banking system or were closed. The pace of bank departures seems to be less this year, but the number of banks in existence still seems to be declining quite rapidly.

The Fed has been keeping plenty of liquidity in the banking system so that the FDIC can continue to oversee the continued decline in the number of banks outstanding in a smooth and continuous way without disruptions or shocks that could cause a further unsettling of the financial system.

With all the restructuring going on in the banking industry, coupled with the new load of banking regulations banks are facing, loan growth had remained tepid or non-existent until just recently when banks started to extend credit at a faster pace. I take this as a good sign and an indication that the bankers are growing a little more confident.

But, deleveraging in the private sector, especially in the United States, has continued. Major debt cycles take a long time to unwind. We can be thankful that major debt cycles only occur about once every century for the working off of debt overloads can take a extended period of time and distract attention from productive activities like manufacturing and construction.

This deleveraging is taking place and, I believe, will continue to take place. Martin Wolf, in the Financial Times, gives us a good summary of how deleveraging is unwinding.

The major takeaway from these examples is that things are improving and the economic recovery is coming along. Sure, there are going to be bumps along the road. Sure, there could be some surprises that could sidetrack us. But, it seems as if people are focused on what things could go wrong and are over-compensating for these possible events so as to avoid surprises. That is, major attention is being given to identify “known, unknowns” so as to minimize the “unknown, unknowns.” It is the “unknown, unknowns” that are the most dangerous things, the things that can really divert the economic recovery.

I believe that the Greek debt restructuring went as well as it did because most of the “unknowns” were on the radar of the participants of the financial markets so that the financial markets reacted smoothly to the settlement that took place. In essence, there were no surprises. (See my post “The Greek Situation: The Financial Markets Do Not Like Surprises” which was posted on March 12, 2012.) It doesn’t mean that everything is settled, it just means that nothing disruptive happened.

So, I continue to argue that the economic recovery will continue, but the growth rate of real GDP in the United States will remain below 3 percent for a while as the deleveraging continues to take place at a reasonable pace. Whether it will be between 2.5 percent to 3.0 percent as projected by the Federal Reserve or remain around 2 percent or below, as forecast by the Congressional Budget Office, is anyone’s guess.

As I mentioned above, however, the modest increase in commercial bank lending is the most positive sign I have seen for a while. Right now, I am leaning toward something above 2 percent but below 3 percent through 2013. Good, but still not robust.

Given this picture, the major problems I see on the horizon are two. First, I am worried that people in Washington, playing for a political advantage, will still feel the need for additional budgetary stimulus in one way or another. I believe that this would achieve very little in the way of greater economic growth because the private sector will continue to deleverage and so the multiplier of any additional government programs would be less than one.

Second, the Federal Reserve must deal, at some time, with all the excess reserves it has injected into the banking system. The dilemma here is that the banking system is still fragile and the FDIC needs further time to help the banking system get smaller in number of banks in existence. On the other side of the equation, however, is the fact that at some time the excess reserves can turn into kindling for the inflationary fires. That is, loan growth could become excessive. In this latter instance, given the current state of the economy, I can see inflation becoming more of an issue without any consequent improvement in the rate of growth of the economy.

The economic system is still very fragile, but the economy is recovering. For now, I believe this is the best that can be achieved.

Source: Economic Recovery: The Good And The Bad