Sunday, October 26, 2008

Economic Outlook: My GDP predictions (or lack thereof)

The first estimates of 2008 Q3 GDP will be released on Thursday (four days from now). I take this opportunity to reiterate my predictions, which have been previously stated in my New York Times article and in my working paper "Market Responses to the Panic of 2008" (I hope the NBER will have that available by tomorrow). My goal here is not to convince you of my predictions, just to make it even more clear what they are.

My basic approach looks at the marginal product of capital -- that is, the profitability of each dollar invested -- in the nonresidential sector and at the wealth and substitution effects of the housing price crash. My model is not much more detailed than that, so we cannot ask it to make especially detailed predictions. In particular, I have plenty to say about how the economy will look a couple of years after the housing crash (in 2009 and 2010) but not much to say about the month-to-month or quarter-to-quarter path for getting there. Moreover, while the financial crisis was at its worst in the last two weeks of Q3, I have suggested that its adverse effects (if any) would have been anticipated in Q1 and Q2, so I cannot even say whether the financial crisis' impact (if any) would be after Q3 or before.

Because of the high non-residential marginal product of capital before and after the housing price crash, the incentive to save is strong, so the real U.S. non-residential capital stock should be significantly higher in 2009 and 2010 than it was in 2006 or 2007. Normally, three years would bring about 6% more real consumption -- and more with a high marginal product of capital -- but the housing crash had an adverse wealth on the order of -3%. So real consumption will be higher in 2009 and 2010 than in 2006 or 2007, but probably not 6% higher. Real GDP and employment will be significantly higher in 2009 and 2010, and so will unemployment, because of the shift in labor supply.

I blogged recently about questions in my own mind about sign of the wealth effect; I continue to investigate them. If the housing price crash turned out to be good news, then 2009 and 2010 employment and consumption should be closer to trend rather than reflecting the wealth effect cited above.

I don't have a model of month-to-month or quarter-to-quarter fluctuations, except that longer term changes are the accumulation of monthly and quarterly changes. With that said, the mechanisms emphasized in the medium term model do make some suggestions as to the dynamics.
My previous writing explained that the financial sector needs a major reorganization, and the auto sector needs new, green, fuel efficient products. In the short term, employment and output will fall in both of those sectors. The vast majority of people are not employed there, but nonetheless finance and autos are included in GDP so GDP and employment will grow less (or shrink somewhat) in the short term until those sectors start to participate. The wealth effect on labor supply my take longer to show itself: for example, delayed retirements will not show themselves overnight.
Early September seems like an eternity ago in economic history, but don't forget that a major hurricane landed in Texas. This by itself will cause GDP to grow less Q2 to Q3.

The medium term fundamentals point toward more real GDP, more employment, and (to a lesser degree) more consumption. Some employment and real GDP declines may occur in the short run, but they will be small by historical standards. Professor Cooley recently explained "The losses to date represent less than .5% of the work force. In the relatively mild recession of 2001 to 2002, job losses equaled about 1% of the work force. In the much more severe recession of 1981 to 1982, job losses totaled nearly 3% of the labor force--six times today's figure. And in the (truly) Great Depression--invoked, now, with an alarmist frequency--job losses between 1929 and the trough in 1933 were 21% of the labor force." Note that 21% over 3 1/2 years is an average decline of 2% every quarter for 14 consecutive quarters! If employment declines 2% in even one quarter, or 5% over a full year, I will admit well before 2010 that a severe recession is happening and that my 2010 forecasts are unlikely to be attained.

According to the BLS, national nonfarm employment was 136,783,000 (SA) at the end of 2006, as the housing price crash was getting underway. Real GDP was $11.4 trillion (chained 2000 $). Barring a nuclear war or other violent national disaster, employment will not drop below 134,000,000 and real GDP will not drop below $11 trillion. The many economists who predict a severe recession clearly disagree with me, because 134 million is only 2.4% below September's employment and only 2.0% below employment during the housing crash. Time will tell.

[Added Oct 28: I notice that's 2008 recession market gives more than a 70% probability of a 2008 "recession" -- that is, two consecutive quarters of negative real GDP growth. At this point, a 2008 recession means negative GDP growth for both Q3 and for Q4, because GDP growth was positive in Q2.

Do to the hurricane, slightly negative GDP growth for Q3 is fairly likely. Negative real GDP growth for Q4 as well is possible. I cannot tell you whether 70% is the right number, just that real GDP will remain above $11 trillion.'s 2009 recession market gives more than an 80% probability of a 2009 recession, although the meaning of "2009 recession" is unclear to me. The contract seems to discuss GDP growth as something that happens WITHIN the quarter, when in fact GDP growth is measured between quarters. So I guess that the contract would pay if real GDP growth were negative 2008Q4-2009Q1 and negative 2008Q1-Q2, but I'm not sure. In any case, 80% seems too high]

Updated. As of October 2008, I had not anticipated that the public policy response would be to pay the unemployed so generously, to the point that millions could make more unemployed than employed. Whatever ultimately depressed the labor market, it was apparently unanticipated by the chief White House Economic advisers, despite the fact that they had at least 3 months more data than I did.]


fscond said...

I went back to the NY Times archives right around the time after the 87 crash. I think you will find the following 2 articles interesting.

LEAD: Defying widespread predictions, the economy has held up well since the stock market collapsed in mid-October and an imminent recession appears quite unlikely, private and Government analysts maintain.

LEAD: As stock prices soared this year, a chorus of pessimists warned that 1987 was looking more like 1929, when a stock market crash helped to usher in the Great Depression. Yesterday, after a plunge reminiscent of the worst days of 1929, one pressing question was whether the aftershocks would be as devastating to individuals and the nation.

fscond said...

If you do the same search, you will find quotes from Bernanke, JK Galbraith and some other high profile economists. The interesting fact is that the quotes are virtually identical to what you will read today from different participants.