Economic Forecast 2011: The Economic Bind

Despite the most aggressive monetary and fiscal measures since the Great Depression, the U.S. economy is sputtering and the federal debt is climbing at a rate of $1.4 trillion per year. Does the economy need additional monetary and fiscal stimulus? Or should we stand pat and possibly risk a double-dip recession?

One would think that a bunch of smart economists sitting around a table could sort this all out. But there is a fundamental problem: The science of economics is not strong enough to provide a definitive answer to every question. This problem is one reason why debates over economic policy often devolve into ideological arguments based on political and economic self-interest.

As a science, the principal weakness of economics is the inability to conduct controlled experiments. For example, we cannot run the economy with and without fiscal stimulus to determine which option is the better course of action. Instead, we have to rely, somewhat imperfectly, on history or econometric models calibrated with historical data for guidance.

The history of presidents who have had to contend with recessions does shed some light on our current economic dilemma. Four of the five past presidents entered office with a slumping economy. President Reagan and President George W. Bush responded with similar economic policies but ended up with quite different results.

Lessons from History
In 1981, President Reagan inherited a double-dip recession (1980 and 1981-82) triggered by the Federal Reserve. In an attempt to halt an escalating inflation rate, the Fed curtailed growth of the money supply. This action sent interest rates to their highest level since the Civil War and caused the housing market to tumble. Housing starts fell by one-half, the nation went three years without adding a job, and the unemployment rate approached 11 percent.

When Reagan took office, he had two objectives: end the recession and win the cold war against the Soviet Union. His first move was to slash taxes. The top income tax rate was cut in three steps from 70 percent to 28 percent, while the capital gains tax rate was reduced from 28 percent to 20 percent. Reagan also increased real defense spending 55 percent during his eight-year term and, to mollify Congress, approved a 30 percent hike in real domestic spending.

What amounted to the biggest peacetime fiscal stimulus package since the Great Depression did the trick. Between 1982 and 1990, real Gross Domestic Product (GDP) rose at a 4.0 percent annual rate (1.0 percentage point above trend), creating 19.8 million jobs and lowering the unemployment rate to less than 6 percent. During the same period, the Puget Sound region added 412,000 jobs, nearly one-fourth of all of the jobs we have today.

Although Reagan espoused supply-side economics, the success of his policy was largely due to its impact on household demand, which represents two-thirds of the economy. The tax cuts greatly increased disposable income, causing consumer spending to surge. In the four years prior to Reagans presidency, household expenditures grew at a tepid 2.0 percent annual rate. During his first term, the growth rate in consumer spending jumped to 4.4 percent. In his second term, the economy also got a big boost from a boom in international trade.

But all this improvement came at a cost. During Reagans reign, the federal debt tripled to $2.7 trillion. He later said that the increased debt was his greatest regret as president. He apparently expected that the rapidly growing economy would generate enough new taxes to pay for his economic policies.

Shortly after President Bush came to the White House in 2001, he was confronted with two major problems: the dot-com recession and the 9/11 terrorist attack. As a consequence, his economic policies resembled Reagans: a reduction in tax rates (the top income tax rate dropped from 40 percent to 35 percent and the capital gains tax rate declined from 20 percent to 15 percent), a 45 percent increase in real defense spending to fight wars in Iraq and Afghanistan, and a 28 percent increase in real domestic spending.

The economy, however, never caught fire. After two years of a jobless recovery, the nation finally began to add jobs in 2004. But the total employment gain during the expansion, amounting to 8 million jobs, was relatively small and short lived.

Why was Bush less effective at kick-starting the economy than Reagan? The simple answer is that the Bush policies had less juice. Bush called for relatively smaller increases in defense and domestic spending than Reagan. More important, however, Bush had little room to reduce taxes and stimulate consumer demand, since Reagan had already beaten him to the punch.

Instead of a broad-based expansion, the economy developed a housing bubble that ultimately culminated in the Great Recession. Low interest rates intended to give the limping economy a helping hand ignited the housing market. Rising home prices, investor disappointment in the stock market and lax regulation led to rampant speculation in housing, the most damaging aspect of which was subprime lending.

With two recessions on his watch, Bush oversaw the worst economy since the Great Depression. Real GDP grew at a 1.6 percent rateone-half the trend rateand the nation lost 900,000 jobs over that 10-year period. During the Dismal Decade, the years between 2000 and 2010, the federal debt increased $8 trillion, reaching $13.8 trillion. Even more catastrophic, the underperformance of the economy over this decade cost the nation approximately $11 trillion in foregone GDP, enough to pay off the federal debt and put Social Security and Medicare on sound footing.

If you believed that the economy was not in trouble when President Obama was inaugurated, consider these statistics: Real GDP, which had already dropped 4 percent, was plummeting at a 5 percent annual rate. Jobs were down 5 million and falling at a rate of 9 million per year. The unemployment rate was 8.1 percent but climbing so fast that it reached 9.3 percent just one quarter later.

Clearly, the economy was headed for a depression. Moreover, it was apparent that it would take a prodigious effort simply to stop the fall. With the assistance of Bush late in his term, Obama and the Federal Reserve launched an attack with a two-part objective: stabilize the housing and credit markets and at the same time, stimulate the economy.

The Successes and Failures of the Stimulus
Today, there is much debate over the efficacy of the federal intervention. In a recent study, Alan Blinder of Princeton University and Mark Zandi of Moodys Analytics used an econometric model to assess the effectiveness of the federal governments response to the financial crisis and the Great Recession. Based on simulations with the modeleconomic sciences work around for conducting controlled experimentsthey came to two conclusions: (1) Without the monetary and fiscal intervention that started in January 2009, the nation would have been in a depression in 2010 (real GDP would have been 11.5 percent lower, there would have been 8.4 million fewer jobs, and the unemployment rate would have exceeded 15 percent); and (2) the efforts to stabilize the financial markets (TARP, bank stress tests and the Federal Reserves quantitative easing) had a much greater positive impact on the economy than the fiscal stimulus.

There are two things to like about this study. Foremost, it calls on critics of the current economic policies to undertake a counteranalysis, thereby initiating a substantive policy debate. Also, according to back-of-the-envelope calculations, the results seem reasonable.

For example, Blinder and Zandi estimated that 2.7 million of the 8.4 million jobs saved in 2010 were attributable to the controversial fiscal stimulus package. In that year, the estimated stimulus spending amounted to about $326 billion, of which $133 billion went for infrastructure projects and transfers to state and local government. Since it takes on average $125,000 to fully support one job in construction and government for a single year, the $133 billion expenditure should have saved approximately 1.6 million jobs (1.1 million directly and 0.5 million indirectly through the multiplier effect). This formula implies that the other $193 billion in stimulus spending for personal transfer payments (e.g., unemployment assistance) and business and individual tax cuts saved 1.1 million jobs.

Other evidence suggests that the federal intervention, despite some hitches, was effective. At the beginning of 2009, when the government jumped into the fray, the economy was in free fall. In the third quarter of 2009, however, national output began to grow again, helping employment to stabilize. In fact, during the past two years, the economy has more or less followed the path predicted by the Blue Chip panel of economists in January 2009, when the ramifications of the new policies were first being factored into their predictions.

But not all is well. The economy apparently lost steam in the second and third quarters of 2010, as real GDP growth decelerated to a 1.8 percent rate. This slowdown is a bit of a head scratcher, but there is a plausible explanation. Stimulus spending, which is presently on the decline, is now a drag on the economy. Certainly, the termination of the cash-for-clunkers and the homebuyers tax credit programs caused a slump in the demand for cars and homes.

Indeed, the economy is in a real bind with no easy way out. Job growth is sluggish and 15 million people remain unemployed. Consumers are wary and the housing market is weak. Cash-strapped state and local governments, the last shoe to fall in this debacle, are only beginning to make significant cuts in programs and jobs. And, given the uncertain future, businesses are still hesitant to start hiring again.

Even the federal governments ability to light a fire under the economy is currently impaired. The effective federal, state and local tax rate is at a 60-year low. Thus, the best Obama and Congress can do with regard to tax policy is to extend the current Bush tax cuts for another year or two, a defensive measure that in itself does not provide any additional stimulus. With the federal funds rate at zero, the Federal Reserves only policy option is quantitative easingpumping more money into the economy and lowering long-term interest rateswith the hope that something productive comes of it. With regard to a second fiscal stimulus package, which strikes me as the best bet to get the economy off the dime, there are two obstacles: a skeptical public, which thought that the initial fiscal stimulus package did not work; and a spiraling federal debt, which is on target to hit $20 trillion in 2015.

All things considered, this picture portends a long, drawn-out recovery for the American economy. The Blue Chip consensus forecast calls for slow growth in the near term. After rising 2.7 percent in 2010, real GDP will increase 2.5 percent in 2011. This pace is likely to result in only a modest gain in jobs. Not until 2012, when real GDP advances at a 3.2 percent rate, will the economy get back on track. On an optimistic note, not one of the 50 Blue Chip economists is predicting a double-dip recession or a bout of troublesome deflation.

Puget Sound on the Edge of a Boom
For the most part, the Puget Sound economy is poised to take off. In particular, Boeing and Microsoft, which directly and indirectly account for about one-fifth of regional jobs, are in good shape. Boeing currently has 3,500 unfilled airplane orders, enough to keep the commercial aircraft division busy for seven years. In October, Microsoft reported that sales in the latest quarter were up 25 percent over the year as a result of strong business and consumer demand. The regions other exporting companies, which are principally engaged in manufacturing, transportation and professional services, have gotten a lift from the recent pickup in the world economy and a weak dollar.

The only question mark is the public sector. For some time, it has been apparent that neither the federal government nor local taxpayers were going to continue to bail out state and local government. Ultimately, the region stands to lose about 10,000 government jobs. If that number turns out to be correct, regional employment growth will remain sluggish and the unemployment rate high well into 2011.

Despite the slow recovery, we are predicting a turnaround in Puget Sound-area employment in 2011. After falling 1.8 percent in 2010, we expect the number of jobs to increase 0.9 percent in 2011, according to our current outlook. This improvement will raise the personal income growth rate from 1.9 percent to 3.6 percent.

The breakout year for the regional economy is now slated to be 2012, when the employment and income growth rates shoot up to 2.5 percent and 5.2 percent, respectively. But full recovery from the Great Recessionwhen employment returns to its 2007 peakwill not occur until late 2013.

During the Dismal Decade, the Puget Sound region saw a net loss of about 1,000 jobs. Over the current decade, the region will add roughly 340,000 jobs, according to our 10-year projections. To understand the reasoning behind this bullish forecast, its necessary to go back 40 years.

During the 1970s, baby boomers and women entered the workforce in record numbers, creating a huge surplus of relatively cheap labor. Businesses mopped it up. The Puget Sound economy, which was one-third its current size, added 319,000 jobs during the decade.

Currently, with 26 million people unemployed, discouraged or underemployed in the nation, conditions are ripe for another labor boom. A drop in labor costs is already being seen. And there is anecdotal evidence that businesses are reversing the trend of outsourcing work. Barring another economic bubblethe economic mistakes of the past decadenational forecasts call for 19 million new jobs between now and 2020.