President Obama this week welcomed the first signs of spring for the economy, and experts have begun debating what comes next. If the U.S. and world economies are close to a bottom, when will the recovery start? To put it bluntly: After having failed, spectacularly, to anticipate so much about this downturn, what is the economics profession now saying about the future?
The current debate reflects the earlier one on how to respond to the recession, which transcended the familiar ideological conflicts about economic policy. Economists have argued for the past 30 or 40 years, for example, about whether fiscal or monetary policy is the best tool to combat a recession. This time, most agree that both must be deployed. Likewise, conservatives have traditionally urged tighter limits on the money supply to guard against inflation, but almost no prominent economists are second-guessing the Federal Reserve Board's moves to triple lending. On the fiscal side, conservatives and liberals stake out familiar positions on Obama's long-term plans to expand government, but few dispute the need for an unprecedented stimulus.
Which isn't to say that economists don't argue vociferously over what caused the recession and how it will end. They do. Understanding the differences is important because they could redefine the economic policy debate long after this financial crisis and recession are over.
As it happens, the poles of this argument were on display last week at an event staged by the Peterson Institute for International Economics involving two of the most widely cited experts on the world economy, both senior fellows at Peterson.
In one corner was Michael Mussa, a former research director of the International Monetary Fund and a genial man with an infectious laugh who has the unsettling habit of chortling while making the direst pronouncements about the economy.
Mussa likes to start out with a joke, and this time it was an easy one, at his own expense: "I will not, of course, review my last forecast, which seems to have been overtaken by events," said Mussa, who delivers the institute's twice-yearly economic predictions. Like almost every economist, he didn't anticipate the swiftness and depth of the recession in the United States last fall and failed to see that the American financial crisis would cause a a worldwide downturn -- on September 26, Mussa was predicting 3.5 percent growth for the world in 2009, when the consensus now is for 0.5 percent growth in the worst recession since World War II.
On April 7, Mussa owned up to these shortcomings and noted the consensus among economists that the world economy would continue to struggle this year and next. Nevertheless, he delivered his own strongly optimistic forecast for recovery in the United States and worldwide starting this summer, predicting that the rebound would be V-shaped, or unusually strong, going from steep descent to rapid ascent.
Simon Johnson, another former IMF research director, presented the other side of the debate. Mussa, at age 65, is part of the postwar generation of prominent economists who came of age in the 1960s; Johnson, 46, belongs to the next generation. His style is very different -- since leaving the IMF last summer and resuming his professorship at the Massachusetts Institute of Technology, he has turned himself into one of the most visible commentators on the world economy. He has a blog, a Facebook page, a Twitter feed, and a taxing schedule of television and radio appearances. He wrote a controversial story in the current Atlantic predicting that the financial rescue plan will fail because banks and hedge funds have corrupted government and dictated its response to the crisis. (The Atlantic is owned by the same company that owns National Journal.)
Likewise, Johnson has a very different prediction for the economy. Whereas Mussa sees a V-shaped recovery that will boost growth to 3.7 percent worldwide in 2010 and 3.6 percent in the U.S., Johnson sees an L-shaped future: little or no growth next year and a lack of a sustained expansion thereafter. Some economists have compared the U.S. economy to that of Japan's in the 1990s, when a financial crisis choked off sustained growth for a decade. Johnson sees the possibility of a "lost decade" for the world economy.
This pessimism, and Mussa's optimism, originate in two very different views of macroeconomics. Mussa bases his forecast almost entirely on a careful analysis of every recession since World War II. And that evidence is clear -- unusually deep recessions are followed by unusually strong recoveries. Mussa finds a lack of stimulus at the heart of weak, L-shaped recoveries and says that this time, the huge fiscal and monetary stimulus will produce a rapid rebound.
Why not include recessions before World War II in the analysis? Because, as Mussa joked when asked by an audience member, "U.S. quarterly [gross domestic product] data only goes back to 1947." There are other ways to measure earlier recessions, Mussa acknowledges, but his reply is revealing. It reflects a view, widely held by his cohort of economists, that practically all he needs to predict the future is a good understanding of the past. Economists have long since settled the question of what the important data are, in this view, and looking for similarities between recessions is the key to predicting what happens next.
Johnson, on the other hand, believes that this recession is sufficiently different from past ones that such comparisons are misleading. First, he thinks that the financial crisis poses unprecedented challenges to recovery because of the outsized role that the financial sector now plays in the economy. He says that the unparalleled loss of home equity will prompt consumers to reduce their spending and to rebuild savings -- not just for the duration of the downturn but for years. Businesses now denied credit will hoard their cash even when prospects brighten, he says, a long-term change triggered by their shaken confidence in the financial system.
A related argument, made at greater length in his Atlantic piece, is that the financial crisis will persist because the government response is inadequate. Conventional economics can't account for what Johnson sees as the corruption of the political process that has allowed banks and investors to manipulate the financial rescue, sowing the moral hazard of renewed crisis. Relying on GDP data alone won't explain this, Johnson argues.
A clue to the conflict between Johnson and Mussa is found in the article, in which Johnson refers favorably to the views of Joseph Schumpeter, an Austrian-American economist and political theorist in the first half of the 20th century. Schumpeter directly challenged many of the tenets of economics that now permeate the profession. In particular, he argued that industrial or corporate elites tend to dominate the political process in nominally democratic countries, interfering with supply and demand.
Schumpeter also questioned the assumption by classical economists that capitalist economies would reliably "self-correct" to seek equilibrium. He rejected the view that recessions bring about recoveries by depressing prices and stimulating demand, returning economies to their long-term growth patterns.
Here is what Johnson had to say on April 7: "While most forecasters expect positive growth in most parts of the world in 2010, those forecasts seem to reflect expected reversion to the mean rather than any identified mechanism for economic recovery. The underlying assumption is that at some point economic weakness becomes its own cure, as falling prices finally prompt consumers to consume and businesses to invest."
This self-correction won't work, Johnson says, if the downturn is pervasive enough. The United States in the 1980s and Japan in the 1990s were able to recover because sufficient demand elsewhere in the world allowed them to build recoveries based on exports. If there is no market for anyone's exports, everyone could be stuck, Johnson argues.
Most economists see the world more or less the way Mussa does, but Johnson and a growing band of dissenters insist on considering factors beyond the familiar numbers. Mussa's discomfort with this view, and the cultural shift it implies, is evident in the video of his April 7 appearance, posted on the Peterson Institute's website. If we can't compare recessions, he said, "then we can just babble on forever without any constraint, and I don't find that particularly useful.... I like to have a story that at least adds up, in terms of the numbers, and [in which] the numbers behave in a manner that is respectful of the regularities that we've observed in the data."
This article appeared in the Saturday, April 18, 2009 edition of National Journal.
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