CAMBRIDGE – For the past six years, I have been skeptical about the standard optimistic forecasts of the pace of US economic growth in the year ahead. Where most forecasters and policy officials saw green shoots and reasons for confidence, I saw strong headwinds that would cause an economic downturn and then a subpar recovery.
But I think the evidence for 2014 is more balanced. Although there are serious risks facing the US economy in the coming year, there is also a good chance that growth will be substantially stronger than it has been since before the recession began.
The economy was still expanding in the late summer of 2007, when I spoke at the US Federal Reserve’s annual Jackson Hole conference about serious risks to the economic outlook. I warned that house prices had begun to fall in the summer of 2006 from dangerously high levels, implying a future collapse of construction activity and large losses of household wealth. Reduced household wealth would lead, in turn, to lower consumer spending, further depressing GDP.
I also stressed that financial markets had become dysfunctional. Banks and other financial institutions had doubts about the value of various asset-backed securities on their own balance sheets and on those of potential counterparties. No one knew the real value of credit-default swaps and of the various tranches of collateralized debt obligations. Financial institutions were therefore reluctant to lend to other financial institutions. With credit flows disrupted, the economy could not continue to expand.
Moreover, I warned that the Fed was too complacent and should be reducing sharply the federal funds rate, which was above 5%. The economy peaked a few months later, and the Fed began aggressive easing in 2008. Although the Fed and the US Treasury cooperated in addressing financial-market dysfunction, this was not enough to restore solid economic growth.
The restoration of normalcy to financial markets and lower interest rates did cause an economic upturn in the summer of 2009, leading many forecasters and market participants to expect a typical rapid post-recession recovery. I warned that the upturn would be much more tepid than expected: unlike previous business cycles, the recession that began at the end of 2007 was not caused by high interest rates, so lowering rates would have little impact.
US President Barack Obama’s new administration announced a three-year fiscal package intended to stimulate aggregate demand. Administration officials and others predicted that fiscal stimulus would cause the economy to rebound, as it had in the past. But the fiscal package was not very effective. It was too small to close the output gap, leaving continued downward pressure on demand. Much of the “stimulus” merely financed increased spending by state governments that would have been paid for in other ways. Other parts of the stimulus went to individuals, but, given the nature of the fiscal package, increased transfers and spending added more to the national debt than to GDP.
When the Fed saw how weak the upturn remained, it launched a strategy of “unconventional monetary policy,” combining large-scale purchases of long-term securities (quantitative easing) with promises to keep the short-term federal funds rate extremely low for an extended period of time. The goal was to encourage portfolio investors to shift into equities and other assets, with the resulting increase in their prices pushing up household wealth and consumer spending. Lower long-term rates were also expected to reduce the cost of mortgage credit, raising the value of homes.
The Fed and others were again overly optimistic about the extent to which these policies would boost GDP growth. Despite the fall in long-term interest rates, house prices reached bottom only in 2012, and the stock market did not rise faster than corporate earnings until 2013.
The economy therefore limped along year after year, with real GDP in the final quarter of each year less than 2% higher than it had been a year earlier. Employment grew more slowly than the population, and annual real-wage increases averaged only about 1%.
Fortunately, the outlook may now be changing for the better. Real GDP growth reached 4.1% in the third quarter of 2013, and fourth-quarter growth appears to have been relatively strong, driven by a dramatic rise in housing starts and industrial production. The sharp increases in the prices of homes and equities contributed to a roughly $6 trillion rise in real household wealth in the 12 months ending in September 2013 – a harbinger of increased consumer spending (at least by higher-wealth households) in 2014.
There are, of course, risks to the pace of expansion in the coming year. Nearly half of 2013 third-quarter GDP growth was inventory accumulation, implying that final sales rose by only about 2.5%. Businesses worry about the potential for higher corporate taxes, especially if the Republican Party loses its majority in the US House of Representatives. Although fiscal deficits are temporarily down, the combination of population aging and higher future interest rates will cause the national debt to rise faster than GDP by the end of the decade. And debt and equity markets may not continue to respond benignly to the Fed’s wind-down of quantitative easing.
So there is still much to worry about. But the US economy has a better chance of achieving a significantly higher real growth rate in the coming year than at any time since the downturn began.