Predictions on the Economy from a Dismal Scientist

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Since most everyone in my extended family knows that I am an economist, I get frequently asked when the recession will end, as if I am Frodo holding the ring to throw into Mount Doom, where Mount Doom is really a combination of Freddie Mae, Citiman Brothers, and Goldman Ford.

So, here goes:

The economy will hit the bottom in the third quarter of 2009 and start slightly trending upward in the fourth quarter. What does this mean, and how will it come about? The Business Cycle Dating Committee of the National Bureau of Economic Research has predicted that

The most likely duration for this recession is somewhere between 18 and 24 months, with the trough likely at some point in the second half of 2009. The magnitude and the timing of large projected fiscal stimulus from the incoming Obama administration in early 2009 could ultimately have some bearing on the timing of the recovery. However, there is a high probability that this could be the longest postwar recession of all (the previous record was the 16-month recession in 1973–75).

(via my company’s chief economist)

What will it take for the economy to turn around, and how will we be able to tell?

Economic growth, the opposite of recession, depends on GDP (gross domestic product.) The economic equation for GDP is

Y=C+I+G+(X-M)

where

C=Consumption;

I=Investment (as in business investment into new machinery, new methods, etc.);

G=government spending and

(X-M)=exports minus imports.

There are several ways according to classical textbook economics to get out of a recession:

1) More government spending to increase G and therefore make Y bigger

2) More consumer spending (which is what Bush was trying to encourage with the stimulus or

3) More business investment through lowered business taxes, giving them incentives to spend more money spreading their business instead of being more cautionary.

So what has to happen in order to alleviate this recession?

  1. The extra supply of houses in the United States must decrease so that demand can catch up and boost the housing sector, the segment most hurt by (and the one most hurting) the economy. This will stimulate consumer spending, as well as business investment. This may happen either through a stimulus package for consumers or friendlier terms on loans by banks. What may also help is the lowered federal funds rate (the rate at which banks loan to each other, which directly translates into the interest that you get in your bank accounts, such as your savings account.)

  2. Friendlier terms on loans by banks, which allows consumers and businesses to put more money into savings. Think about it, would you rather save money at a 2.4% interest rate (the current rate on my ING account) or at 4.5% interest rate? While the Federal reserve is trying to stimulate spending by keeping interest rates low, as rates increase, banks will have more money to lend out, resulting in more loans and more business investment. You’ll notice that in the GDP equation, some parts can balance others out.

  3. Oil prices need to remain low in order to lower investment prices for businesses. If you’ve been listening to the news, businesses are constantly talking about how operating costs have increased. Transportation costs, of which oil is a part, have had a large role to play in that; however, this may be hard to do given that OPEC is already trying to instate production cuts to hedge its losses.

4.  Consumer demand needs to increase, which may or may not happen with Obama’s proposed stimulus package.  While this helps in the short term, it gets us into more debt in the long term.

The problem is that the economy is not a closed laboratory that can be operated on. It is a living thing with so many millions of moving parts that it must be a nightmare for the Fed, the Treasury, and other regulators.  This is one of the reasons that economics is an imprecise science at best.  Even if you increase consumer confidence, what’s to say that investment will also increase?

Also, are government policies efficient?

These are the questions facing policymakers, as well as academic economists, and one of the reasons it is next to impossible to do anything about a recession right away.   One thing that helps, though, is public sentiment.  So, if you think positive, and your neighbor does, and investment in stocks starts again, which starts a chain reaction, the economy may become healthy again.