The economic outlook for 2010 and beyond

Most economists are forecasting very sluggish growth for 2010 - in the 2.5 to 3.5 percent range - which would keep unemployment around 9.5-10 percent. Meanwhile I, under the spell of Bob Barbera, have been arguing that growth is likely to be much higher than that, with the result that the unemployment rate could fall by much more by the end of the year. How much more? Bob and I are working on an op-ed piece that suggests that 8.5% is a reasonably conservative guess for end-of-2010 unemployment.

The high-frequency data seem to bear out our rosy forecasts. Consumer spending high this Christmas season, the housing market struggling to life, inventories bouncing back pretty dramatically. But the recovery skeptics have some strong arguments to make for slower growth in 2010. What are my counterarguments? Why do I believe what I (think I) believe?

I've been scratching my head over this question and I think the answer is, I don't have a strong case to make for why we should expect strong growth. I can't pinpoint one sector of the economy that is poised for takeoff. Instead, my argument is that the US economy has always in the past recovered strongly from deep recessions. 1975 and 1983 are the most recent examples, but the post-1933 recovery from the Great Depression was not shabby either. The burden of proof, it seems to me, is on those who would argue that this recession is different. Their arguments seem to me not persuasive. A partial listing of these arguments includes:

Everyone's forecasting slow growth. But everyone is always wrong at business cycle turning points. The conventional wisdom missed the 2007-09 recession as well as the 1975 and 1983 recoveries.

The banking system is a mess, consumer finances are a shambles, there's a looming foreclosure crisis, state and local governments are going to be cutting budgets this year, etc. All true. But these problems are always with us at the trough of a recession (though they're clearly more severe this time around than they have been in the past). Economic growth makes these problems much less severe. Give me 3 million jobs in 2010, and I'll give you a much lower rate of foreclosures than you forecast.

With interest rates at zero, there's no way for the Fed to stimulate our way out of this one as it has in the past. It turns out this is untrue on several counts. First, the Fed has found ways to stimulate the economy despite the "zero bound." Second, if we use interest rates on risky assets like BAA corporate bounds as our measure of whether monetary policy is tight or loose, we find that the actions the Fed has taken in the last year have had a tremendous loosening effect - BAA bond rates are at normal recession levels now, down from sheer panic levels a year ago. Third, it turns out not to be true that the Fed looses during recoveries. The loosening tends to occur before recovery begins, tightening during the period of recovery. Today the Fed is maintaining a loose policy into the period of recovery. Finally, if we combine fiscal and monetary policy, I think we can argue that never in the history of the US has macroeconomic policy been as stimulative as it is today.

Are there any positive reasons to expect strong recovery? I would point to extraordinarily strong monetary and fiscal stimulus, a return to normalcy by many indicators (risk spreads are at normal recession levels, housing inventories are nearing mid-2000 levels); pent up demand for things like automobiles; and the effects of a depreciating dollar. Further out, it's possible that green energy will be the next investment boom, especially if Congress gets its act together and passes cap-and-trade. But such things are impossible to predict with any accuracy. How many people in 1993 were predicting the dot-com boom?

For 2011 and beyond, I see possibilities but no proof positive of strong growth. The main drag on growth will be sluggish consumption spending. We can't continue on a path in which consumption is 70 percent of GDP. It has to fall to something more like 65 percent. What sector will pick up the shortfall? I don't think we can expect investment spending to increase very much from its historic average. Government spending on infrastructure, education, energy research and development should rise somewhat. But the biggest compensating movement will have to come from net exports. We need to reduce the structural current account deficit from the 5-6 percent range to something more like 2 percent. That will require a reduction in the value of the dollar. If that happens, then it's not hard to imagine a period of reasonably strong growth fueled by a revival of manufacturing and a switch in the composition of spending from tradeable to nontradeable goods.

But getting a depreciation will be difficult, because the value of the dollar is determined not by US policy but by the central bank of China. Macroeconomic policy coordination with China will, I think, be the central sticking point in the next five years. Solve that and we've got a chance for a strong, sustained period of recovery and growth. Screw that up, and we've got a world of problems.