My needle has moved to the right on my pessimism-optimism scale, and I’m not sure why. It has a lot to do with the recent performance of the stock market-- a pretty good measure of sentiment, as well as one of the better leading indicators of real economic activity. I don’t have much more than a hunch and a hope, but I now expect real GDP growth to exceed four percent in 2011 and 2012 and don’t really see why it couldn’t exceed five percent.
This renewed growth will have to happen without much help from the housing sector, whose bleak prospects have been made worse by the humpty-dumpty scrambling of mortgage and foreclosure documents. Still, while housing sits on the bottom, its downward impetus, like much else, has dissipated.
Unemployment will remain high for years, but it should begin moving down soon, relieving the fears of the still-employed that they will soon be added to the unemployment roles. Declining unemployment will be a tonic available in small but increasing doses in 2011.
The European debt crisis is bound to flair up periodically during the year, but it no longer scares us so much on this side of the pond. The big countries of Europe are becoming resigned to supporting their weaker sisters in whatever way is necessary. In any case, we don’t have much directly at stake in that arena. A further weakening of the Euro will help Europe’s recovery at our expense, but so many people here believe that a stronger dollar will be beneficial to the U.S. that it well may become a self-fulfilling prophecy—logical or not.
The main non-psychological reason for my greater optimism is that the paradox of thrift doesn’t seem to be the strong negative drag on total spending that I had feared. Consumers still need to save more, and continue reducing debt, and I had thought that would hold increases in consumption spending to zero or below. It turns out that consumers are still spending while beginning to save as well. That bodes well for consumers and their improved habits going forward, but it still isn’t serving its usual function in the macro-economy, which is to free up resources to finance investment. In the past couple of years, much of the saving by consumers has been of income received through transfer payments from the government, which were borrowed. Thus, more government dissaving has offset more consumer saving. Nevertheless, better saving habits by consumers are welcome and promise to be beneficial in the future.
The other huge cause for less pessimism is the compromise on taxes. We didn’t get a big tax cut, but we did avoid a huge tax increase at the worst time possible. That removes a big worry holding back activity. Another positive on the tax front is the inclination shown by the various commissions to move in the direction of supply-side tax reform by trading fewer deductions for lower rates. If that momentum is sustained we could move significantly toward lower marginal rates. The urgency on cutting the deficit and new debt generation might make loophole closing less impossible that it would be otherwise.
The growing size of the budget deficits and debt relative to the size of the economy is clearly unsustainable. So much so that it is hard to imagine spending cuts sufficient to close the gap. Marginal tax rate cuts might bring needed new stimulus to the economy, but in most cases probably at the expense of deficit reduction. In other words, I believe that marginal tax rate cuts work to stimulate the economy, but, in most cases, probably not enough to completely pay for themselves. The corporate tax rate may be an exception to that. Also, repatriation of corporate earnings stranded abroad to avoid double taxation may be a potential windfall. It’s a shame that the payroll tax relief for workers wasn’t matched for employers, since the latter would have been a direct incentive to hire more workers.
It seems impossible to dig ourselves out of our fiscal hole by spending cuts, even though we should certainly try. The only chance of success, in my opinion, is faster economic growth than we have allowed ourselves to hope for recently. However, with the unemployment rate so high, with capacity utilization so low, and with so much general slack in the economy, there is no reason that real growth can’t exceed long term “full employment” averages for some time to come. The low inflation rate makes the additional monetary stimulus in train now less risky and more likely to make its impetus felt in the real economy. If enough of us believe this, it will happen.