Previously Published March 22, 2011
Forecasting is a challenge in rapidly changing times, and these are very rapidly changing times. At the beginning of the year, it would have been unbelievable if someone had said that Mubarak would be deposed, we would be in a war in Libya, and there would be general uprisings throughout the Middle East, and all in the first quarter. But all this and more happened. Certainly Japan’s earthquake, tsunami, and near nuclear meltdown were unpredictable.
Because of the uncertainty, it seems particularly important that we provide our assumptions to forecast users. First though, you should know that we have included the impacts of the of Japan’s tragedy as best we can. We assume that their exports to the United States will fall only minimally, while their imports will increase. We also take the aggressive assumption that they will complete rebuilding in only eight years, increasing world gross product and demand for United States exports.
There are other issues with Japan that we cannot model. Because of our integrated world economy and just-in-time inventory management, Japan’s manufacturers may be suppliers of critical components of products that are ultimately produced almost anywhere. To the extent that rolling blackouts and other infrastructure issues interrupt Japan’s manufacturers’ ability to promptly deliver critical goods, worldwide production could be hurt. It is impossible to know exactly how important this is, but we believe it will be small relative to world output.
High oil prices pose the most real and immediate risk to United States economic growth, but forecasting political changes in the Middle East is impossible. But of course, oil prices have huge economic impacts. While it seems to be general consensus that the Great Recession’s proximate cause was financial in nature, Jim Hamilton at UC San Diego provides very compelling evidence that high oil prices were a significant contributor.
For our baseline forecast, we assume that world oil prices do not exceed $120 barrel. We also provide an alternative scenario where prices reach $150 per barrel. This scenario generates another recession. The recession appears to be moderate, but we must remember that this is a change in output from a low base. Our unemployment is still very high. The higher oil prices go, and the faster they rise, the worse the recession. Certainly, the forecasts of potential oil prices go much higher than $150 a barrel. Our scenario is thus only suggestive of the economic impacts of general Middle East turmoil.
United States and world financial institutions are still not recovered from the crisis of September 2008, which implies a susceptibility to new financial shocks. For our forecast, we assume no new significant financial shocks. However, the possibility of new financial shocks cannot be ignored. The possibility of some sort of Eurozone crisis arising from the sovereign debt issues of several European countries is relatively high. It is our opinion that the Eurozone is too large to be a single currency. Ultimately, it must break up. How the breakup is accomplished will have major economic consequences.
Problems in United States’ municipal markets could also provide a problem for our already-weakened financial sector. States and local governments are facing very serious financial challenges, and it appears that citizens are unwilling to increase taxes sufficiently to solve those challenges. Unfortunately as we have seen in Wisconsin and elsewhere, the other option, shrinking government, is a very challenging business.
These sorts of risks have been with us for some time, and we have previously provided scenarios of a new financial crisis. Suffice it to say, that a new financial crisis would cause another serious recession.
After having assumed away, justifiably we think, the most frightening options, we still come up with a soft forecast. It is better than we’ve seen over the past few years, but this recovery is far less robust than most, held back as it is by still-weak financial institutions and real estate markets.
We expect United States economic growth to be positive, but annualized quarterly economic growth rates (GDP) will likely remain well below three percent throughout most of 2011.
We expect job growth will be even weaker, with barely-above-one-percent annualized growth rates. This rate is insufficient to significantly reduce unemployment rates, if labor force participation rates remain unchanged.
However, we’ve seen steadily declining labor force participation, to the lowest level in decades, for several quarters. This is a result of the discouraged worker problem. Millions of Americans have been out of work for extended periods. Eventually, many of these workers just give up and leave the workforce. Those who do not give up face increasingly difficult challenges in finding a job, as human capital deteriorates of becomes obsolete.
Productivity growth continues to impress. In recession or not, United States productivity has shown remarkable strength. The trend has been strong enough to outweigh the cyclical impact for each of the past two recessions.
Productivity growth has been cited by some as a reason for our high unemployment. This cannot be true. The history of the world since the industrial revolution has been one of increasing productivity and increasing jobs. Rather, weakness in jobs is a result of a weak small business sector (see the Economic Activity essay) and structural changes. Some industries face real challenges filling open positions, while millions are unemployed or underemployed. Medical care has continually seen job gains, while millions of construction workers have been displaced. It takes time to turn a construction worker into a healthcare worker.
All this is to say that it looks like the recovery will continue to be soft and fragile. We expect to see job growth, welcome job growth after years of decline, but many challenges remain.