GDP growth is still subdued

GDP growth in 2010Q1 was 3.2 percent according to the BEA's advance estimate. That's weaker than I thought it would be - I guess the consensus is smarter than I give them credit for. 3.2 percent is not strong enough to bring the unemployment rate down at a satisfactory pace. For that we need growth in the 4-5 percent range for the next year at least.

On the broader question of what type of recovery this is going to be, however, the data for Q1 confirm (for me at least) that we're on track for a traditional recovery rather than the jobless recovery that so many economists are worried about. For the first three quarters of this recovery, GDP has grown at a 3.6 percent annual pace. Compare that to the growth rates in the first three quarters following the 1990-91 and 2001 recessions: 2.0% and 2.3% respectively. The last two recoveries were jobless for a simple reason - GDP growth was too slow. We are on track, I think, for a recovery like that following the 1974-75 and 1981-82 recessions. Following those two recessions, GDP grew at a 4.5% and 6.1% rate respectively for the first two years of the recovery - I'd bet on a 1975-77 recovery rather than a 1982-84 recovery however.

Why the confidence? First, there's the fundamental statistical properties of GDP growth in the past few decades. If you run a regression of GDP growth on a constant, the output gap, and two lags of GDP growth, you find that typically deep recessions are followed by periods of strong growth: every one percentage point output gap adds about a third of a percentage point to annualized quarterly GDP growth. Our current output gap of about 5.9 percent therefore provides a powerful impetus to growth in the coming quarters: the model predicts a growth rate of 5.2 percent for the next four quarters. If we use the model to forecast the next four quarters of growth from a point three quarters into the recovery following the last two recessions, we get much lower forecasts: 3.6% for 1992 and 1.7 percent in 2002-03. Now the standard errors for these forecasts are very large, and in fact growth was somewhat higher than the model predicted in 1992 and somewhat lower in 2002-03 (4.2% and 1.7% respectively). So I'm not going to bet a lot of money on 5.2%. But the point is that strong growth coming out of a recession like this is normal, as is weak growth coming out of a recession like the last two. If you want to convince me that growth will be considerably slower this time around, you have to explain how the economy has changed. And no one has done that to my satisfaction.

The latest GDP report calls into question the most powerful argument that has been advanced for a slow recovery. Economists have been arguing that consumer spending is going to be sluggish during this recovery because households are heavily indebted and housing prices have fallen so much. But consumption spending rose 3.6 percent last quarter, following a 2.8 percent and 1.6 percent increase in the preceding quarters. As long as employment continues to pick up (and I think it will), consumption spending should be able to maintain the current pace for the foreseeable future. Business spending on equipment and software, traditionally a powerful cyclical indicator, was likewise strong last quarter, growing at a 13.4 percent annual pace. This indicates that business investment is not being restrained by problems in the banking sector, another of the headwinds that growth-pessimists focus on.

Weak spots last quarter were business investment in structures - a consequence of overbuilding in commercial real estate during the boom - and spending by state and local governments. There's not much we can do about investment in structures, but state and local government spending should be less of a drag as budgets improve along with recovery. Congress should long ago have provided more relief for state and local governments, and if I were in charge I'd press for this now.

The key to turning this into a self-sustaining recovery, of course, is growth in employment. Here again I think we can rely on statistical regularities for a powerful argument for employment growth in the coming quarter. A regression of employment growth on the previous three quarters' output growth suggests that in the second quarter employment should increase by 624,000 jobs, or just over 200,000 per month. If you think we're going to have considerably less employment growth than that, you have to explain how companies have been producing at the recent pace without hiring more workers. I don't think there's a convincing argument for that. It's more likely that we'll see stronger growth in employment than this - as Bob and I wrote in our Financial Times article a few months ago, companies probably overshot in reducing employment in 2008-09, and now will need to hire at a faster pace to get back to normal staffing levels. I'd bet on monthly employment gains of 250,000 or so for the next three months.