Barack Obama is an outstanding politician. Parties all over Europe would be happy to welcome such a smart, pragmatic and likeable politician in their ranks – but there is one thing that seems to be common to all politicians regardless of their political color or personal character – especially when they are in charge: they are forced to bring us good news rather than bad news. And we should not blame them for this.

However, it is the job of economic forecasters to critically review the politicians’ statements and to tell the truth – whether it’s good or bad news. And if we do not know the truth it is our job to analyze and point out risks that the economy might face in the future. Politicians have designed and decided on huge stimulus packages that are meant to support economic growth in the course of the year 2009. Barack Obama is leading in numbers with his USD 789 bn (approx. 5.5% of GDP) package recently passed by Congress. Many of the stimulus packages – of which only the USA’s and China’s are comparable as a percentage of GDP, while the stimulus packages passed in Europe only amount to roughly half of that percentage – will not prove effective in the short term. They will help to support growth in 2010 or later (e.g. investments in infrastructure, schools or renewable energies).

Thus I fully agree: The growth forecasts given by governments are far too optimistic due to the fact that the underlying stimulus packages are not as effective in the short term as they are supposed to be.

Personally, I spoilt the rosy picture painted by the government in Germany by saying that GDP might decline by 5% in 2009 – and was vilified by politicians, entrepreneurs and the public. Nevertheless I am sure that it was the right decision. To stop forecasting entirely or to be overly optimistic is not the right way to go in difficult times.

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“Our question of the week:  “Is The Economic Forecast Too Optimistic?” triggers some thoughts I would like to share with my fellow “expert” bloggers.”  I’m not sure that the Administration’s baseline forecast before -- and I want to stress before -- its policy recommendations was too optimistic.  

Few soothsayers predicted the 6.2 percent drop in GDP in the 4th quarter and the weaker economy we now face.  However, I do worry that their projections of growth this year and next are too optimistic because I fear both the beginning and the nipping in the bud of a recovery from the Administration’s policy prescriptions, especially from the anti-growth, short and long term, of trying to restore a 19th century tax code to the 21st century rather than making our tax structure more appropriate for our time, more pro-growth or at least competitive with the rest of the world.  

Finally, what about erring on the side of pessimism or optimism in an economic downturn when the loss of confidence among the general public, investors and business is so great?  

It reminds me of a conversation Mrs. Roosevelt had with an admirer, who remarked:  “Please tell Mr. Roosevelt that when he talks to the nation at his fireside chats, it’s like he talks to me directly.”  President Obama shares this ability to connect directly with the American people at a critical time.  I worry that his ability to maintain the great American middle class’s confidence in our mixed free market could be dissipated with what both friends and foes fear is a lack of specificity in the avalanche of new initiatives.  The Washington Post editorially worried about a lack of a singular focus on the economy rather than a broader social and political agenda.   The Wall Street Journal editorialized on the initiatives as anti-growth tax policies.  Several prominent Democratic wise men and women from prior Administrations publicly and privately fear is a lack of fiscal discipline in the long run.

This deep recession will end sooner or later but unless we address the long-term fiscal imbalance, to be blunt, a serious downgrading of the nations credit rating with all of its frightening consequences is not out of the question.  I challenge the goal of the President’s budget, a 3 percent deficit after ten years. Shouldn’t we aim for a surplus over the course of the business cycle to provide for another chapter in the American dream?

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The forecasts of the CBO, Federal Reserve and the administration are probably too optimistic, for  technical, psychological and political  reasons.

First, the underlying baseline models incorporate the notion of a natural rate of unemployment. This is an arbitrary  rate to which the economy is assumed to return automatically over time – even if no action is taken. CBO pegs this rate at 4.80 percent and builds a five-year reversion period into its model. There is no foundation in real life for this.  The implicit idea, drawn from textbook theory,  is that real wages will fall to adjust the labor market. In real life this does not happen (real wages have risen inn this slump so far), and  even if it did happen, it  would not quell unemployment.

Second, agencies may be tempted to make their forecasts rosy in order to try to foster confidence among the broader public, and perhaps to avoid a charge of complacency in the face of disaster. It may be better to appear not to see the disaster, than to appear to accept it.  

Third, the White House and OMB may favor rosy scenarios because they reduce projected budget deficits, which eases political problems.

Fourth, mechanical forecasting models built around self-stabilizing assumptions will not generate outcomes outside the range of experience on which they are estimated.  Therefore, in a slump of extreme violence, forecasts will never capture the rate of decline. The starting point for recovery will therefore be lower than forecasts of this type expect.

Fifth, the administration is assuming that its policy of bank bailouts can somehow raise the growth rate of new bank lending.  This is very unlikely to succeed, because it misunderstands the nature of the banking problem. So long as the administration fails to face the realities of the mess in the financial sector, the underlying sources of the credit collapse will not be dealt with. One consequence is that multiplier effects from spending increases and tax cuts may be smaller than expected.

These sources of false optimism tend to corrupt fiscal planning, so that expansion programs in deep slumps are likely to be too small, and designed to terminate too soon.

On the bright side, there is the fact that the automatic stabilizers are large and effective: taxes fall and spending rises in a slump, increasing disposable income and improving household balance sheets. And the expansion package as enacted does a good (though incomplete) job of stemming the state and local budget crises, for the moment.

Putting all of these pieces together, it is reasonable to expect that the economy will eventually stabilize and return to positive growth -- but, crucially, at a lower level of activity and a much higher rate of unemployment (or lower rate of employment) than the official forecasts allow for. And the growth rate may not be sufficient to restore high employment in any reasonable time.

The Levy Economics Institute Strategic Analyses (http://www.levy.org/ ) provide useful guidance here. Contrary to the CBO, Fed and administration, they foresee unemployment above 8 percent indefinitely.




 

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Since I am not an economic forecaster, I have no special advantage in predicting the future course of the economy.  Nonetheless, I have been surprised by the comparative optimism of both the Administration's and the Federal Reserve Board's forecast of economic growth over the next couple of years. 

An optimistic forecast has a clear short-term advantage.  A pessimistic forecast might cause consumer and investor confidence to erode faster, contributing to the drop in private demand.  For the Administration there is a second short-term advantage.   With an optimistic economic forecast, the budget outlook looks less frightening.

The Administration can pay a price for an over-optimistic forecast, however.  Congress may be less persuaded that a large stimulus is needed.  Like many other economists, I worry that the stimulus the President asked for is too small in light of the weakness in consumer and investor demand.  An over-optimistic forecast may also carry a price in terms of popular political support.  At this point, most Americans blame the Bush Administration for the nation's economic catastrophe.  If the current Administration promises a milder recession than the one that we actually experience, voters may conclude that the shortfall in performance is due to the Administration's own policies, including its tax and spending policies and its handling of the banking crisis. 

When Democrats run for office in 2010 and 2012, they will find it helpful if the economy is performing better than expected rather than worse than expected.  By helping to form voters' expectations about the future course of the economy, an over-optimistic forecast can lead voters to judge the Administration's performance more harshly than would be the case if its initial economic forecast were more pessimistic.

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The Reid/Pelosi/Obama economic plan is to empower trial lawyers to sue more often, spending a 800 billion on earmarks rejected by previous congresses,  funding 9000 more earmarks, raising taxes on income, investments, dividends, capital gains and exporters, eliminating pesky elections that hamper the Teamster’s organizing drives, sending tens of thousands more American troops to Afghanistan (Iraq without the flat bits), subsidizing those banks that wasted the most of their depositors money, and increasing the power of Washington DC.

            This, they predict will create economic growth.  

            Each of these projects have been tried by other nations in the past.  Track record is not encouraging.