Los Angeles Daily News
When will the economy recover?
By Robert Krol
Posted: 04/05/2009 12:00:00 AM PDT
Forecasters expect the current U.S. recession to end sometime during the second half of
this year. The Obama administration's budget projects 3.2 percent real GDP growth in
2010, with 4 percent growth expected in 2011 and 4.6 percent in 2012. How reasonable
are these forecasts?
One option is to compare the administration's forecast with private forecasters. The
Federal Reserve Bank of Philadelphia surveys 43 private forecasters every three months.
The most recent average forecast for real GDP growth in 2010 is 2.2 percent, a full
percentage point below the administration's forecast. The president's economic team is
considerably more optimistic about the strength of the recovery than private-sector
analysts.
Another way to judge the administration's forecast is to compare it to past economic
recoveries. Looking at the last 10 U.S. economic recoveries, the average real GDP
growth rate during the first year of recovery was 5 percent, 3.7 percent in the second
year, and 4.2 percent in the third year. The president's forecasters are more conservative
than the historical average during the first year, but more optimistic in the later years of
the forecast.
Forecasting is only an informed guess of the future performance of the economy.
Forecast errors tend to be larger when the economy is in recession. There are two reasons
for this.
First, understandably, forecasters have a hard time predicting the actual turning point in
the economy. Second, they tend to over-estimate the strength of the recovery by giving
too much weight to the impact government stabilization policies.
At this time, there are a number of reasons to go with the conservative forecast of the
private sector over that of the administration. Historically, downturns that occur because
of a financial crisis tend to be longer and deeper.
Even if housing prices stabilize, a large unsold inventory of homes needs to be worked
down before construction resumes. The continued uncertainty about job losses along with
substantial wealth declines due to the fall in housing and stock prices will be a drag on
consumption for some time to come.
Significant expansion in lending will not begin until the balance sheets of financial
institutions are strengthened. This will not occur quickly. Months after the initial
announcement of a substantial federal effort to bail out the financial sector, it remains
unclear how the Treasury plan to remove toxic assets from the books of U.S. banks will
work. Problematic accounting rules continue to force financial institutions to downgrade
the value of their marketable assets. This reduces bank capital, which constrains lending.
The recently passed stimulus package will result in a dramatic increase in government
debt. This debt must be repaid with higher taxes in the future. The expectation of higher
tax rates and lower after-tax disposable income in the future can be expected to
discourage some investment and consumption today.
Furthermore, the heavy reliance on borrowed funds to support increased federal
government spending will drain financial markets of money that would have supported
consumer spending or business expansion.
The Federal Reserve has followed a very expansionary monetary policy. While lowering
the Federal Funds rate during a recession makes sense, the historic increase in liquidity
has the potential to be highly inflationary down the road.
In an unprecedented effort to keep financial markets liquid, bank reserves and currency in
circulation have more than doubled in the last 12 months. To avoid inflation, the Fed will
be forced to tighten monetary policy once the economy begins its recovery. This could
stall the recovery, destabilizing the economy.
The current U.S. recession may end up being the longest in post-World War II history.
The policy response, with heavy federal borrowing crowding out access to credit for
consumers and investors, misguided efforts to resolve the problems of U.S. financial
institutions, and problematic accounting rules that continue to drain bank capital, is less
than encouraging.
Given the seriousness of our current economic problems, a robust and sustained recovery
is not likely.
Robert Krol is a professor of economics at CSUN and can be reached at
robert.krol@csun.edu.