Saturday, October 25, 2014

Looking Up in 2014?

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.

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  1. CommentedLuis de Agustin

    As more likely to disagree with Dr. Feldstein, it's good to be on the same side of the equation on this one.

    On this, the US economy, David Ranson, president and head of research of Wainwright Economics & Co. is also on the same side.

    Credit spreads keep saying the outlook for world growth has continued to improve in the last couple of months, though less rapidly than earlier. The price of gold in US dollars has been stable or down in the last couple of months. That implies a stronger dollar and a reason for optimism about the US economy relative to the rest of the world. For the US this is the best combination of conditions for performance – as long as it lasts.

    The advisor’s first monthly conference call provided clients as much. Ranson expects for 2014, mainly from past-year changes in gold and spreads indicators: improved worldwide growth; temporary speeding up of the US economy; slight decline in government estimates of US inflation; a continuing advance in the US stock market; little change in US interest rates; conditions moderately favorable for B-grade junk bonds and TIPS; near-neutrality for a much wider range of other asset classes, including emerging equity and sovereign debt markets, C-grade junk bonds, and commercial real estate.

    The big question is how long will the US mini-recovery last. Wainwright believes the answer should be based on their two selected pivotal leading indicators. Spreads would have to continue narrowing and the price of gold would have to fall further. But spreads have been stabilizing as indeed they had to, given how tight they already are.

    Luis de Agustin

  2. CommentedZsolt Hermann

    Of course we don't have prophetic vision to tell what is going to happen next year or beyond.
    But we have learned a lot in the last few years through the daily events of the crisis and based on that we can provide some predictions.
    More and more people start to understand that constant hquantitative growth in a closed and finite natural system is not possible. And when we talk about natural system it means the human resources too, not only the natural resources usually considered.
    And it is these human resources that are already exhausted.
    When people talk about aggregate demand it in fact means the brainwashing marketing giving people to produce and consume good, products and services they do not need for a normal, modern human lifestyle.
    And they also need means beyond their capacities to maintain the over consumption which drive people and nations into intolerable debt burdens.
    If there are no fundamental changes in the way the economy is structured, change in the whole paradigm, lifestyle, societal values we are pursuing, the crisis will deepen to a breaking point beyond which everything becomes unpredictable and volatile.
    We simply cannot afford to sit back within the same misguided framework hoping for a nutcase that by doing the same somehow things will turn to the better.
    Einstein famously said that problems cannot be solved at the same level they were caused at, we have to change our thinking, or attitude, start a completely new human state starting with education about how to adapt to the global, integral conditions we evolved into, instead of trying to fashion the world around us to or misguided perception.

      CommentedEdward Ponderer

      I can't but wonder at the seeming detachment of economics from reality on the ground, as mathematics is detached from the given realities of our physical universe. To wit, it was as though one studies cosmology insisting on using Euclidean geometry instead of following Einstein's advice to use the obtuse geometry of Riemann who axiomatic system is more in tune with the reality of space-time curvature.

      The world is round, not flat, and it is reaching its market, natural resource, and waste management limits. No gloom and doom because if economy adjusts to actually needs instead of accelerating production detached from the actual needs--in fact devoted to artificially generating "needs," for those products--then the Earth can replenish, heal.

  3. CommentedProcyon Mukherjee

    Could not agree more on all the points raised. The looming paradox is striking: the equity markets are roaring while the economy is trudging and the developing economies of the world have passed on the truncheon to the developed, where U.S. is leading the pack with the value-add per capita.

    It remains to be seen that when the monetary accommodation starts to mellow down, what are the consequences of the Banking Glut that could follow closely and how the effect of the resultant intermediation on the asset prices (which had helped to prop up some of them) makes wealth effects move to the plateau.

    But 2014 can only be stronger, with many tailwinds that could counteract the effects of the headwinds that Mr. Feldstein has chronicled.