Business Forecast 2005 | Chicago & New York

 

Randall S. Kroszner
Professor of Economics, Chicago GSB
Associate Director, Stigler Center for the Study of the Economy and the State
Former Member, President’s Council of Economic Advisers (2001-2003)

 

The Rodney Dangerfield Recovery

I told my psychiatrist that everyone hates me. He said I was being ridiculouseveryone hasn’t met me yet.

Rodney Dangerfield, No Respect

 

With the release of the updated GDP data yesterday [Tuesday, November 30], it is now official: the US has experienced six straight quarters of rapid economic growth. The growth rate has average of 4.6 percent per quarter, ranging from a low of 3.3 percent in the second quarter of this year (still above our average post-1960 growth rate of 3.2 percent) to an astonishing 7.4 percent rate in the third quarter of last year. October marks the 14th consecutive month of job gains for the nation. More than 2.4 million jobs have been added since the labor market turned around in August, according to the payroll survey of employment. Even employment in the manufacturing sector, which had been steadily and consistently declining for years, has turned around: more than 79,000 jobs have been added in manufacturing since bottoming out in January. The unemployment rate is at 5.5 percent, below its average in each of the last three decades. Inflation remains quite low and stable. Mortgage interest rates remain near historic lows and long-term interest ratesboth real (that is, adjusted for inflation) and nominalalso are quite low.

But you read the press or talk to people in the street and they say that the economy is sputtering (or many use more colorful language not appropriate for such an august gathering). To quote that renowned scholar and star of Back to School, Rodney Dangerfield, the recovery just don’t get no respect. Just as no matter what Rodney Dangerfield did, he simply couldn’t get respect, the economic statistics have been consistently strong for 18 months, but no one seems to give the economy any respect. Well, that’s not completely true, since the U.S. stock market has added roughly $4 trillion in value during that period and foreigners' capital market continue to pour in $1 billion to $2 billion dollars per day into the U.S. But why quibble with what everyone knows to be true, about both Rodney and the economy. For instance, given that we are now in the holiday shopping season, Rodney could tell that his parents hated him. His bath toys were a toaster and a radio! When Rodney met the surgeon general, he offered Rodney a cigarette!

Unfortunately for me, all of this good news about the economy started coming out just after I resigned from the CEA on July 4, 2003my independence day. (No, I wasn’t indicted. My leave from the U of C was up and I chose to return rather than give up tenure at this great institution.)

I arrived in Washington in the summer of 2001 as one of three members of the President’s Council of Economic Advisers (CEA) and was confirmed by the Senate that falland what a fall it was. Damned to live in interesting times and boy was I damned. We had the horror of 9/11 and the beginning of the war on terror; we had the crisis in Argentina involving the largest sovereign debt default that sent shock waves through emerging markets around the world, with risk spreads growing of the next two years to unprecedented levels and countries such as Brazil and Turkey on the brink. We had the revelation of the corporate governance scandals, when it was Enron all the time in Congress and in the media. We had the revisions of the GDP data that showed the economy contracting during the first three quarters of 2001, when the initial data suggested simply slow growth. Finally, we had the worse stock market performance since the Great Depressionand I take full responsibility. Note that when rumors of my departure began to circulate in spring of 2001, the stock market began its sharp rise. I’ll take responsibility for the $4 trillion too, thank you.

In this incredibly uncertain environment, I had to try to forecast the economy. To formulate the official White House economic forecast upon which the entire U.S. budget is based, I chaired the so-called Troika 2 process (known by inside the White House types as T-2, not to be confused with Terminator 2). The Troika consists of the CEA, Treasury Department, and the Office of Management and Budget (OMB). A series of technical as well as big-picture meetings occur. Then, exactly at this time of the year, I would write the memo with a forecast for acceptance or modification by Troika 1, that is, the Chairman of the CEA, Secretary of Treasury, and the Director of OMB. In each case, the forecasts in this memo were accepted and became the basis for the federal budget submitted to Congress.

Since I am new on the GSB panel, you will see on the forecasting scorecards on your tables that I have not made a single errora perfect record (or at least that’s how we would spin it in D.C.not a word is false but perhaps not quite on point). To provide you with some information about my forecasting prowess, let me report these real GDP predictions and actuals for ’02 and ’03. (These predictions can be found in the Economic Reports of the President.) In December of 2001, I predicted that real GDP would grow at 2.7 percent when in fact it grew by 2.3 percent. Thus, I was overly optimistic by 0.4 percent. In December of 2002, I predicted that real GDP would grow by 3.4 percent when in fact it grew at 4.4 percent. Thus, the next year I was overly pessimistic by a full percentage point. (We predict in terms of Q4 to Q4 growth rates, for those taking out the magnifying glass.) My average forecast error thus was -0.6, that is, the official forecasts were too pessimistic by more than a half of a percentage point. Gloomy, not rosy scenarios coming out of my time at the CEA.

That reminds me of a Devil’s Dictionary definition of a cynic and what they think about flowers that I’ll apply to economists: Economist, n., An economist is a person who, when he smells flowers, looks around for the coffin. If you don’t like that definition, here is another one from an eighteenth century French scholar: An economist is a surgeon with an excellent scalpel and a rough-edged lancet, who operates beautifully on the dead and tortures the living.

Obviously, I don’t think that the economy is dead and I'm an optimist in looking to the future. I predict 3.9 percent real growth for next year, which is almost a half percentage point above the consensus. I would now like to explain the basis for the optimism of my forecasts. First concerns policy, specifically both monetary and fiscal policy. The dragon of inflation, while not slain, certainly has to be caged and declawed. Monetary policy over the last three years to four years has been gracefully well balanced to provide support for economic growth without generating inflation. We have had some of the best inflation performance in years: low and stable rates of inflation, which helps to reduce uncertainty and keeps both real and nominal interest rates relatively low. That is one key ingredient in promoting economic growth. My inflation forecast is for 2.3 percent increase in consumer prices next year, which, given the way we measure inflation, overstates the true increase in costs of living by almost a percentage point.

The members of the CEA would have a monthly lunch at the Fed hosted by chairman Greenspan. He would also invite other members of the Governors of the Federal Reserve. He was often a bit late, having come in from the golf course or tennis courtnot bad for a man nearly 80. He makes it all look easy. We would discuss a wide range of economic and finance topics but never interest-rate policy. The chairman is a generous host but a very independent one, as it should be. My forecast for who will replace chairman Greenspan when the Federal Reserve Act will force him to retire in January 2006, well, we can talk about that later. I do predict that the Fed will continue their policy of .25 percent point increases in the Fed Funds rate for at least the next two meetings of the Federal Open Market Committee (FOMC) and likely continue until the short rate is above the measured inflation rate, probably taking a pause when Fed Funds rate is between 2.5 percent and 3.0 percent, which would put short real rates back in positive territory.

A second aspect of policy that has received just a small amount of attention during the election campaign is fiscal policy. In 2001, at the high point for surplus projections, the Congressional Budget Office (CBO, now run by my former chief economist at CEA) estimated that the federal government would have a $5.6 trillion dollar surplus for the fiscal years 2002-2011. The most recent CBO estimate for the same 10-year period is $3 trillion.

What happened? With all of the shocks that hit the economy in 2001 that I listed above9/11, recession, corporate governance scandals, emerging market crises, war on terrorit is no surprise that the fiscal position of the U.S. would change dramatically. Some have argued that the tax cuts were a major culprit; however, the data say otherwise: The CBO estimates that increased spending (on defense, homeland security, and elsewhere in the budget) accounts for 39 percent of this change, the weak economy that results in a smaller tax base and higher outlays on entitlement programs accounts for 37 percent of the change, and the tax cuts account for 24 percent of the change. The most recent budget just passed reigns in spending in many areas and that’s why I predict that real government expenditures will grow by no more than 2 percent, roughly half of the rate of growth I am predicting for the overall economy.

Obviously, with the re-election of the president, those tax cuts are likely to be made permanent. The White House also has discussed undertaking wide-ranging tax reform: everything from a replacement of the income tax system with a consumption tax or value-added tax system is on the table. Fundamental tax reform, however, will tax a long time to work out and then work its way through the Congressand the lobbyist meat grinderso it is unlikely to take effect in 2005.

The key element, however, is that the president is keen to continue to pursue tax policies that enhance economic growth. Consider, for example, the reduction in dividend taxes in the Jobs & Growth package passed in 2003, just before I left the White House. There had been no constituency lobbying for the elimination of this heavy tax on capital, except for the long-standing objection of economists that this double-tax was highly distortionary and inefficient. The president became convinced that such pro-growth tax reforms, however, were the right way to go. Even in France, that well-know low tax haven, you receive a check from the government reimbursing you for the double-taxation of dividends.

And this policy has worked: an unprecedented number of firms have initiated regular dividend payments, and for firms already paying dividends, regular dividend payments have increased significantly.

More rapid expensing of investment and bonus expensing also has helped to boost non-residential fixed investment. A number of the special bonus incentives will expire in the first quarter and so there is likely to be a spike in investment then. Overall, I predict robust growth in real business investment of 9.5 percent and continued strong growth in real after-tax corporate profits of 12 percent. (Litigation and tort reform is also high on the President’s agenda because the tort system now effectively acts like a tax on business activity but, again, there is unlikely to be major change that will affect growth in 2005.)

Another important aspect of the tax changes that are likely to be continued is the reduction in the top marginal rate for income tax, down to 35 percent from 39.6 percent. This certainly helps small business owners and entrepreneurs who effectively pay the top marginal tax rate on their enterprises. Also, and this is often forgotten, a new 10 percent tax bracket was created for the less affluent. Overall, these tax reductions have been able to boost real disposable income and keep the consumer buying. (Also, as an aside, the changes in the income tax have maintained the progressivity of the system: different income group pay roughly the same proportion of income taxes under these changes as they did before the reforms were enacted.) With the continuation of these policies, I see continued strength in real consumer spending, which I predict to grow at 3.1 percent in the next year.

I don’t see the unemployment rate declining sharply during the next year. I estimate only a small reduction from the current 5.5 percent level to 5.3 percent. This is not because I think that the economy’s job production rate will fall; quite the contrary. It will continue to stay at solid levels but I believe that the labor force participation rate, which has been unusually low, will rise. Given the way unemployment is measured, as more people become optimistic about the economythat is, give the economy the respect it deservesand look for work, that will offset the solid job creation of roughly a couple of hundred thousand jobs per month to leave the unemployment rate moving down only slightly during the year.

Where does this leave the fiscal deficit for 2005? With the economy doing well and spending coming under control, I see the fiscal deficit shrinking from roughly $413 billion this year to $330 billion next year. While these number are large, they must be seen in the context of the size of the economy, which will be roughly $12 trillion in 2005. The deficit is roughly 3.5 percent of GDP and my prediction implies that it will be under 3 percent next year. These are perfectly manageable numbers, particularly when we recall that the overall debt to GDP ratio in the US is under 40 percent, lower than most developed countries and dramatically lower than in Japan where the debt to GDP ratio exceeds 150 percent. When put in this perspective, we can see why there has been little effect of the deficit and change in the fiscal position of the U.S. on interest rates.

I also predict that the U.S. economy will continue to grow faster than most of the rest of the developed world. This has important implications for the trade balance. Despite some decline in the dollar, the U.S. will still be importing significantly more than it is exporting. I see the trade deficit rising to $625 billion in the next year.

What does this mean for the dollar and the economy as a whole? I think that the pronouncements about the death of the dollar are, to say the least, premature. The fact is that the dollar increased in value steadily from the mid-1990s until reaching its peak in roughly 2001. On a trade-weighted basis, which is what is relevant for both producers and consumers in the US, the dollar is only 14 percent off of its all time high. This is not a death spiral but a gradual and perfectly orderly readjustment.

Even if the dollar were to decline dramatically, and I do not believe that it will, there is little evidence that this would harm the economy overall. Think back to the 1983-1985 when the dollar skyrocketed against major currencies such as the Yen and then just as quickly dropped by roughly half. Recall this was the time of what were seen as high fiscal deficitspeaking at nearly 6 percent of GDP. What happened to growth, interest rates, and the stock market? No discernable effect. The economy grew steadily in the mid-three percents, interest rates came down from their highs after Volker broke the back of inflation, and the stock market continued on its steady growth in that decade. Thus, even a sharp reduction in the value of the dollar need not have deleterious effects on the economy, contrary to what the doomsayers have been predicting, for years I may add.

So on this optimistic note let me conclude with a little stock market adviceI’ll leave the forecasting of the level of the S&P to Joel. When I was a graduate student, I was on the CEA as a junior staff economist. I arrived in the fall of 1987 and we all know what happened to the stock market in October of 1987. As I mentioned, we had the worst stock market performance since the Great Depression during my recent tenure in D.C. but things turned around as I was forecast to leave. So if you ever see my name in the papers as going back to D.C., sell and sell short. Thank you.