“The only economic forecast in which I have complete confidence is that the economy will not evolve along the precise path implied by our projections.”
Ben Bernanke
Having come through a pretty horrendous economic cycle, replete with financial crises, mammoth declines in net worth, double-digit unemployment, massive loss in output relative to potential, aren’t we due for a sustained period of decent growth? I think we are, but there is a large and seemingly growing chorus of naysayers. These negative commentators point to a long list of obstacles to growth, including de-levering, weak housing, upcoming tax rate hikes, increased regulatory burden, high unemployment, budget cutbacks at state and local governments, and negative international shocks, to name a few.
But surely there are some bright spots as well. Corporate profits are up substantially off their lows, real GDP growth has been growing for fourth consecutive quarters, and monthly job growth, albeit modest, has turned positive. Incomes are rising and consumption spending has stabilized. Most important, business investment spending is picking up quickly and business executives are significantly more upbeat than the caste of economic prognosticators.
Moreover, pessimistic forecasters are fighting some pretty powerful long-term trends. In particular, modern free market economies have a natural tendency to grow. At least, they have since about the turn of the 19th century. Before then, this was not the case. As best as we can tell today, for thousands of years prior to 1800, output per person didn’t increase much at all. But that changed with the advent of the industrial revolution. Since then output per person has been steadily growing and the rate of growth appears to be accelerating. With population growth of about 1% per year and trend productivity growth of about 2%, capacity output is increasing in the U.S. today at a rate of about 3% per year. We have been hit by a series of negative shocks, including the housing bust and financial crisis, which have pushed us way off the long-term growth path. By various accounts, current output is 8-10% below capacity.
Not only does capacity output show a strong tendency to grow, but actual output demonstrates a strong tendency to remain aligned with capacity output. It is likely that actual output will increase faster than capacity growth over the next few years, so as to diminish the “gap” between potential and actual output.
A large output gap implies large quantity of resources that are not being fully utilized, this includes unemployed workers and idle capital. What process will cause correct this imbalance? In a market economy, the answer is adjustment in market prices. The relative prices for resources formerly deployed in hot areas that are no longer hot (for example, housing construction and mortgage lending) decline and incent these resources to move toward areas now in greater demand. Which areas are those? It is hard to say because the process is pretty complicated, but it seems like natural candidates would include alternative energy, education, health care and entertainment. Public policy should focus on improving the information process so as to hasten these adjustments.
Lots of people do not want to rely on the market process, fearing that it will not work properly or will not produce desirable outcomes. It is commonly argued that market forces do not take into account quality of life issues, like pollution, education, infrastructure, or health care.
Yet, research suggests that quality of life issues are being addressed. In their book “It’s getting better all the time” economists Julian Simon and Stephen Moore track the progress during the 20th century on a host of economic and quality of life indicators. They conclude that on just about any measurable indicator of wellbeing, there has been dramatic improvement during the past 100 years. These indicators include disease eradication, increasing longevity, improving education, lower pollution levels, and lower commodity prices.
What is the process by which these results have been achieved in the face of ever-present obstacles? Simon and Moore argue that the key driver of progress is the application of brainpower to complex problems in an environment of economic freedom and private property rights.
But even if you acknowledge the Simon and Moore data and argument, a fundamental question is one of limits. Presumably there are limits on material advancement. Are we approaching some sort of limit? It does appear that today we face huge short-term problems and obstacles to advancement. But that probably has been true for each epoch in the past, and will be the case at each point in the future. Simon and Moore posit that it is precisely the existence of enormous difficulties that drives the long-term progress! By that logic, it seems like we should welcome overwhelming problems, in that they will provide a real stimulus to innovation and growth!
Forecast
A fundamental point is that we are currently running at about 10% below capacity in terms of aggregate output. Will this condition continue or will it change? Economists do not agree. Keynesians argue that, absent massive government fiscal stimulus, it is entirely possible that less than full employment equilibrium can persist. Milton Friedman countered this idea with his own theory of economic cycles – the Plucking theory. According to the plucking theory, occasionally events conspire to draw output below the full employment level. This is the negative shock. Following this, a market economy will react quickly to create a new equilibrium at full employment. The “plucking” idea is that the process is like pulling down an extended string, which when released moves back toward its original placement. There is no consensus among economists that a depressed economy is more likely to bounce back like a plucked string rather than remaining depressed. Still, my reading of economic history is that the former proposition is more likely than the latter.
Returning to the economic forecast, I think we will see significant pickup in business spending, inventories and exports, and more modest increases in consumption spending, imports and (I hope) government spending. Policy actions may present further obstacles. Increases in taxes on investment will retard investment and growth, but should not derail them.
The Fed is likely to keep short-term rates very low for the next year or two, and the yield curve will remain historically steep. Inflation will remain close to zero. Profits will continue to show strength, jobs will follow.