Back in the game?

The Financial Times piece Bob and I wrote in January predicting a "job-rich" recovery is still taunting me from the bulletin board in the department office, so I'm tempted to lie low. But here goes.

The argument for a strong recovery was that (1) deep recessions are ordinarily followed by strong recoveries; (2) this is largely because in deep recessions companies cut employment excessively, businesses and households cut back spending excessively, and when the dust settles they snap back to something approximating normal; that applies to this recession-recovery episode; (3) monetary and fiscal policy are tremendously expansionary. At the same time a number of "headwinds" were tending to push growth down: the housing market, consumer debt, state fiscal problems, etc.

I thought that the forces of expansion would overpower the headwinds, and a growing economy would relieve pressures from the weak housing market and so on. I still think that argument is right, but I did not count on the European crisis in the spring to so royally screw things up. I now believe (with something approaching the confidence that I have that the Packers will go to the Superbowl) that the growth slowdown was due not to the forces of expansion being weaker than I gave them credit for, but to uncertainty surrounding the European debt crisis. My evidence for this is the coincidence of credit spreads rising at exactly the time of the slowdown in employment: here's the graph.

Private sector employment growth (the blue line) was increasing steadily throughout 2009 and into the first quarter of 2010, headed for the 200-300,000 per month range. Then Europe happened, credit spreads (the difference between Baa and Aaa bond yields, in red) rose, and employment growth leveled off. Now it's possible that the slowdown was due to some other factor and that credit spreads were predictive of rather than responsible for the slowdown in growth. But I think that the European crisis is the most plausible explanation. Either way, credit spreads are now returning to the levels they were at the beginning of the year. I predict that this signals a return to progress toward a healthy expansion in employment.

The signs of renewed strength are all around us - Calculated Risk has the run-down. On the basis of the recent indicators, CR predicts growth of 3%+ in 2011, which is significantly more optimistic than the consensus forecast of around 2.5%. But I'm more optimistic: I don't think I was wrong before about the fundamental sources of strength in the economy, so I don't see why we couldn't see growth around 4%, with growth in employment of say 200,000 or more per month, and a substantial (1% or more) decline in unemployment. We'll have better indicators of employment growth in November after the ADP and ISM reports come out, but I'm going to guess on the basis of spidey sense that it'll be somewhere near 200,000.

Of course, everything I've just written comes with a giant caveat: if Europe collapses or the US experiences some kind of fiscal crisis (say because Republicans refuse to raise the debt ceiling this spring unless Democrats repeal health reform), all bets are off. Indeed, the Baa-Aaa spread has stopped falling since October, probably in large part because of the Ireland crisis. This is a bad sign.