I have nothing but sympathy for those economists compelled, or who feel compelled, to deliver detailed forecasts of GDP, prices, the value of the dollar, the unemployment rate and other economic variables at the beginning of each year. And this year their crystal balls must be cloudier than ever, witness the wide range of forecasts, some expecting the economy to grow by more than 3%, others foreseeing no growth at all or even a decline in economic activity.
A prominent economist, at one time a leading figure on the British Treasury team, recently wrote, "Forecasting errors are largest when the most is happening in the economy." It is difficult to imagine more happening in the economy in 2009 than actually did, and 2010 should be no different. And predicting where the economy is heading is made even more complicated by important known unknowns, and the key role policy will play.
Those known unknowns include the possibility that Iran might explode a nuclear device or Israel might make that impossible; Islamic terrorists, who failed in their recent attempt to blow up an airliner over Detroit, might succeed in an attack on New York, London or some other major financial center, or on the Saudi oil fields.
An even greater source of uncertainty is the policymaking duo of Barack Obama and Ben Bernanke. In 2009 the president poured gallons of red ink over the nation's ledgers, while Bernanke's Fed printed money with which to buy up Obama's IOUs. There are hints that Obama and Bernanke, or both, will reverse course this year. The president says he plans what his staff calls "a pivot" early in the New Year, and will announce plans to rein in spending in the long run, which of course is not quite the same thing as doing it now. And the Fed is pointing to the various techniques available to it to sop up the excess liquidity with which it has flooded the system -- when it deems the time is right.
Which means that to predict the economy circa 2010 we are reduced to doing what John Maynard Keynes suggested if we want to pick the winner of a beauty contest -- don't try to pick the prettiest face, try to pick the face the judges will deem the most beautiful (I paraphrase). Guess right on how Obama and Bernanke will see things, and you have a winning prediction of economic activity in the new year.
The safest guess is that the president and the Democratic Congress will continue to run up the budget deficit. The House of Representatives already has passed a second stimulus, which dare not speak its name, and the president will soon sign a health care bill that will spill more red ink over the nation's ledgers. Then come unlimited billions for Fannie Mae and Freddie Mac, the quasi-government mortgage agencies that account for something like 80% of all new mortgages.
Meanwhile, the Fed has made it clear that so long as the unemployment rate stays high, the financial and housing markets remain fragile, and credit remains difficult for small businesses to come by, it will not tighten, at least not a lot. Critics of the president and the Fed argue that the policy of big deficits, continued low interest rates, and money creation has failed. The unemployment rate has risen from 7.6% at the beginning of last year to 10%, and the number of long-term unemployed (out of work for more than 26 weeks) has more than doubled, to almost six million. Throw in mounting foreclosures, hundreds of failed banks, and business' reluctance to invest, and you hardly have a testimonial that Lord Keynes would like etched on his tombstone.
To which the response is: because of these policies the financial system did not collapse, the latest report showing a drop in jobless claims will likely be followed by a report that the economy is actually gaining jobs, the housing market is firming up, and even the bloodied dollar is showing signs of strength as investors guess that the recovering economy will drive interest rates up, increasing the attractiveness of dollar assets.
My own guess is that all of this means that the wind is blowing in the direction of a continued recovery, to borrow a phrase from my Sunday Times (London) colleague David Smith, and one more rapid than most observers are expecting. Consumers unzipped their purses late in the Christmas shopping season despite the absence of the deep discounting of recent years, and the presence of midwinter storms that kept even the most devoted "mall rats" at home -- shopping on the Internet. Share prices are up, and investors cheerier, in part because they don't take account of inflation when toting up their gains: factor inflation in, and it will take a further share price rise of 25%-30% to get them even with 1999 levels.
The important housing sector seems to have bottomed out, with sales of existing homes and prices both up a bit. But here is where policy -- difficult to forecast -- becomes crucial. If the Congress allows existing tax credits for first-time buyers to lapse, and the Fed withdraws its several supports for the mortgage market as it says it will, mortgage rates will rise, perhaps enough to abort a housing recovery that is fragile at best. Both programs are scheduled to end early this year, one in which voters will decide the fates of all members of the House of Representatives and one-third of Senators. It is anyone's guess whether these politicians, many already under pressure because of their support for the unpopular health care bill, will risk allowing these programs to die, and with them their careers in public office.
None of this is to say that policy making is all that matters. Far from it. Consumers account for some 70% of U.S. economic activity, and in the end are the ones whose reactions to policies will drive the economy. So it is good news that personal incomes and wages rose last month, and that the savings rate seems to have stabilized at around 5%, high enough to prevent a return to the negative rates of the spendthrift '90s, not so high as to put a crimp in the recovery.
Businesses, too, matter. Right now profits are good, and they are sitting on a pile of cash. But uncertainty as to the cost to be imposed upon them by the new health care "reform," the impending carbon cap-and-trade bill, and by the prospect of a huge boost in their tax bills, makes them reluctant to invest and to hire.
All in all, it is not unreasonable to guess that the wind will blow in a 2010 that is better for most people than 2009. Except for the congressmen who have to explain to their constituents why the budget deficit is projected to continue at levels that in the long run might well produce a wave of inflation, and for future generations that will have to bear the burden of trillions in government IOUs.
By Irwin M. Stelzer:
Reprinted with permission from The Weekly Standard