Happy Days Are Here Again!
Don’t believe the naysayers: An economic recovery is right around the corner.
Photograph by Justin Sullivan/Getty Images.
Economic forecasting is a mug’s game. There are simply too many unknowable factors that affect “the economy” for anyone to make accurate predictions. The Fukushima earthquake and nuclear disaster, for instance, had a noticeably negative macroeconomic impact around the world, and nobody knows what lurks inside the hearts of central bankers. Plus, if I did possess the secrets to the future, I’d be making a fortune as a speculator, not telling you about it.
Still, the application of economic theory should be able to help us avoid the commonplace error of simply assuming that the future will be like the past, that after 18 months of sluggish growth we’re due for sluggish growth to continue. The conventional wisdom is that the relatively strong growth in the fourth quarter was a false dawn, and the economy is destined to stall out. This is mistaken. Some tragic unforeseen disaster could hit us, but if it doesn’t we should be in for a string of increasingly strong quarters and accelerating growth that put us back on the path to full employment.
My guru in this prediction is Karl Smith, an economist at the University of North Carolina, one of the authors of the Modeled Behavior blog, and one of the few sources who saw through the cloak of pessimism this past summer and accurately called for a strong close to the year. But in a deeper sense, I’m following the long-dead Swedish economist Knut Wicksell, whose work is so fundamental that people sometimes forget to return to it.
Wicksell argued that there is a “natural rate of interest,” at which desired savings is balanced by desired investment and the economy suffers from neither inflation nor massive excess capacity. A recession occurs when the natural rate of interest falls below the actual interest rate. Instead of savings being channeled into investment and driving the economy forward, firms and households start merely hoarding and the economy stalls, leaving workers and equipment idle.
Wicksell’s work leaves open the question of why the natural rate of interest might rise or fall, so it doesn’t make for much of a causal theory of recessions. But under normal circumstances central bankers can cure recessions by cutting interest rates to bring them closer to the natural rate. This brings saving and investment back into equilibrium and ensures that resources are put to good use.
Unfortunately, the financial crisis we’ve been suffering through pushed the natural rate very low—below zero. The Fed can’t set the nominal interest below zero, and has steadfastly refused to engage in the variety of “unorthodox” measures that would push real rates lower, thus ensuring a long and painful recovery process.
The important thing to note, however, is that each month of recovery closes the gap between the natural rate and the rate the Federal Reserve is willing to set. The downward creep of unemployment from 10.1 percent in October 2009 to 9.7 percent a year later to 9 percent in October 2011 and then down to 8.6 indicates a rising natural rate of interest. And while the Fed has refused to resort to exotic moves to push rates down further, they’ve committed to holding nominal rates where they are until the economy recovers. There’s no precise precedent for the situation we’re in, since the Fed’s never hit zero before. But the basic mechanism of a narrowing gap between the natural and actual interest rates has been behind all of our recoveries from postwar recessions and the same logic applies today. Improvement will lead to further improvement, with the economy growing rapidly as idle resources—workers, machinery, storefronts—are put back into use.
What will this recovery look like in concrete terms? Total bank credit, which collapsed during the crisis, is growing again and will keep growing. That will make it easier for Americans to buy new cars and reverse the four years of growth in the average age of America’s passenger vehicles. Families will also invest in other kinds of durable goods—refrigerators, washing machines, etc.—that they’ve been hesitant to upgrade or replace. The housing bust, meanwhile, has been followed by an epic construction slump that’s actually left us with a shortage of homes. But every downward tick in the unemployment rate is another twentysomething moving out of his parents’ basement, stimulating a return to a more normal level of construction. Multifamily housing starts are already up 80 percent over the past year to accommodate the likely coming flood of renters, and there’ll be more to come once people have more cash in their pockets.
This increase in economic activity will boost state and local tax revenue and end the already slowing cycle of public sector layoffs. Re-employment in the construction, durable goods, and related transportation and warehousing functions will bolster income and push up spending on nondurables, restaurants, leisure and hospitality, and all the rest. Happy days, in other words, will be here again.
None of that means we’ll remember 2012 as the best of times. What we’re talking about is a spurt of rapid employment growth from a low base, not a tight labor market and rapidly rising wages like we had in the late ’90s. But compared with the past four years, it’ll look like a magnificent boom.
Unless, that is, policymakers screw it up. If you imagine a world in which several million people go from unemployed to daily commuting, and large numbers of people abandon their roommates and get a place of their own, then there are likely going to be spikes in the prices of gasoline, rent, and other commodities. This will temporarily push inflation above normal levels and increase pressure on the Fed to tighten money and nip the boom in the bud. The central bank’s recent statements indicate that they won’t do this, but they haven’t been as clear as they should be. Betting against policymaker screw-ups is a risky proposition—the Eurozone elite managed to spend the entire fall acting in bizarre and counterproductive ways—but barring a trade-destroying natural disaster, we’re looking at a recovery, if we want one.