Paul Krugman's economic pessimism

Let me stipulate up front that a year or two from now we may look back at the state of the macroeconomy in 2009 and 2010 and see that Paul Krugman's dire forecasts were exactly on target, and we should never have paid attention to that Char Weise fellow and his rosy scenarios. And you'd be crazy to put more faith in an obscure macroeconomist at a small liberal arts college than a Nobel Prize winning Princeton economist. Yet more and more I'm convinced that Krugman is wrong, dead wrong in his gloomy economic forecasts. And the Brad DeLongs and Mark Thoma's of the blogosphere who echo his views are not giving enough credence to the case for a strong recovery. I've given some reasons for optimism in previous posts; let me devote this one to itemizing the fallacies that Krugman and other doom-and-gloomers have been committing in the past few months.

Fallacy #1: Paying too much attention to high frequency data. In his most recent post, Krugman worries about the decline in construction employment and the latest downturn in the ISM manufacturing index. On the former issue - it's winter, 'nuf said. On the latter issue: though the ISM index fell from 55.7 in October to 53.6 in November (above 50 means expansion), it's still higher than it's been since May 2006. And the trajectory is up, sharply: it was 32.9 last December. Squiggles happen, it's crazy to put much stock in every one.

Fallacy #2: Paying too much attention to economic forecasts. Krugman frets that professional forecasters are predicting sustained high unemployment through 2012. But professional forecasters always get these things wrong. As I noted in a previous post, the professional forecasters vastly underestimated the strength of the post-1975 and post-1982 recoveries, and completely missed the current recession. They were right about the recoveries that began in 1991 and 2001, but overall their track record is not impressive.

Fallacy #3: Forgetting about data revisions. Unemployment is what it is, it's never revised dramatically. It's also an unreliable barometer of the state of the labor market because it is affected by flows into and out of the labor force. But payroll employment - we have no idea what payroll employment is right now. This number is always revised, and tends to be revised upward in the early stages of recovery. Ditto GDP. I believe the economy lost jobs in the third quarter and probably also in the fourth quarter. I believe the economy will gain jobs in the first quarter of 2010. We won't know for sure until we see the revised data, a couple of years from now. Until then, month-to-month declines in payroll employment cannot be taken as concrete evidence of a "jobless recovery."

Fallacy #4: Seeing monsters under every bed. Mortgage delinquencies, commercial real estate, state budgets: all of these are seen as impediments to a strong recovery. But at every business cycle trough there are going to be signs of weakness in the economy - that's why you're at a trough! These things are endogenous variables. A strong recovery raises household income, improves corporate balance sheets, increases state tax revenue, and all of a sudden things that seemed like barriers to growth don't look so bad after all. Case in point: last fall, Krugman, Roubini and others argued that the banking system was insolvent and needed to be nationalized. Why? Because many of the assets they held were virtually worthless. But guess what: in a financial panic, assets are priced way below their fundamental values. When the panic subsides, asset prices rise and balance sheets don't look so bad after all. The US government has pumped money like mad into the banking system. The money has had the effect of quelling the panic and restoring asset prices to reasonable (recession, not panic) levels. This has improved bank balance sheets to the point where most of them have been able to repay the government loans. Nine out of ten of the banks that were identified as susceptible to further economic downturn in the Treasury's stress tests have raised the required amount of capital from private sources. Bank stocks have risen dramatically. The banking system is not, it turns out, insolvent: it was illiquid, and the government was able to deal with this problem without having to nationalize the whole mishagosh.

So I think Krugman is wrong about the weakness of the recovery. I hope he's wrong. Because there's a chance that he's not, it still makes sense for the government to do many of the things Krugman recommends: the Fed needs to keep interest rates low, there needs to be another round of fiscal stimulus focusing on jobs and state budgets. But there's no need to go all Chicken Little with every new data release.