Former IMF Chief Economist Michael Mussa on Recovery: Throw Out the Forecasts

We all know the story: The economic recovery has begun in the United States and the rest of the world, but it will be sluggish and disappointing. Shell-shocked and over-borrowed American consumers will spend less and save more. Financial markets remain traumatized, so don't expect much of a boost from new consumer lending or corporate investing. Global trade is rebounding, but slowly, from huge declines. The only question is whether the recovery will be W-shaped (a double-dip recession), U-shaped (a slow and shallow expansion) or L-shaped (bumping along at the recession's trough). Except now comes economist Michael Mussa with a simple message: WRONG.

Mussa, a former chief economist of the International Monetary Fund now at the Peterson Institute in Washington, argues that the recovery will defy the prevailing pessimism. From mid-2009 to the end of 2010, he says, the U.S. economy will grow almost 7 percent, about double the 3.3 percent gain envisioned by the 50 or so economists in September's Blue Chip Economic Indicators. The world economy will also outperform, says Mussa. In 2010, growth will rebound to 4.2 percent from 2009's decline of 1.1 percent. By contrast, the latest IMF forecast in July has a 1.4 percent drop in 2009 and a feeble 2.5 percent gain next year.

The dueling forecasts imply vastly different outlooks. By the consensus, U.S. unemployment will peak at more than 10 percent and remain high for years. In 2014, it will still average 7.6 percent, says IHS Global Insight, a major forecasting firm. Sluggish economic growth won't quickly absorb today's big jobless pool plus new workers. Indeed, stubbornly-high unemployment virtually guarantees lackluster consumer spending. Fearful of losing their jobs, Americans skimp. Nonsense, says Mussa. Joblessness will peak just below 10 percent and by 2014 will drop "to the neighborhood of 5 percent." (Ed. note: This figure was initially reported as 9 percent, which would be impossible, since unemployment has already exceeded 9 percent. In fact, Mussa said joblessness would peak just below 10 percent. We regret the error.)

What makes him so much more optimistic?

It's not that he completely rejects today's conventional wisdom. American consumers, he says, have retrenched-and will continue to do so. He thinks the personal savings rate will rise from 5 percent at the end of the second quarter of 2009 to 7 percent by year-end 2010. (Note: in 2007, it was only 1.7 percent.) Still, consumer spending will increase, albeit at a slower pace. But Mussa sees something larger driving recovery. He invokes the Zarnowitz Rule, named after Victor Zarnowtiz, a leading scholar on business cycles who died earlier this year: deep recessions have steep recoveries.

No one doubts that this recession has been deep, so why wouldn't there be a rapid recovery, Mussa asks. Even by his arithmetic, he says, the rebound will be only two thirds as strong as average recoveries from the 1950s through the 1980s. Consumers and professional economists alike are always too pessimistic in the midst of or just after a recession, he argues. They almost never see sources of faster economic growth.

Yet, he argues, these abound. One benefit of the housing collapse is that there's ample upside. Housing starts are about 500,000, down from a peak exceeding 2 million. Home prices seem to have stopped falling after a decline of about a third, and the combination of low interest rates and reduced prices means affordability is at levels not seen in decades. With dramatically reduced inventories, companies will have to restock. That, too, will boost production. Similarly, corporate investment in machinery, computers and software has plunged 22 percent since the start of the recession, leaving much pent-up demand. It will revive.

Mussa also likes the outlook for many other countries. After brief pauses, China and India should resume rapid growth, 9-10 percent in China and 6-7 percent in India. He thinks the Zarnowitz Rule will apply to Brazil and Mexico, too, which he expects to grow 3.6 percent and 3 percent, respectively, in 2010. All this implies stronger demand for U.S. exports and, given the dollar's recent depreciation, only a modest deterioration in the U.S. trade balance as a recovering America buys more imports.

As for the financial sector, Mussa agrees that it will take years to repair itself fully, but doubts that its weaknesses will threaten overall recovery. Most forecasters, he contends, misread history. They think that the economy can't recover without a strong financial sector. He thinks just the opposite is true: recovery in the real economy of production and jobs restores the financial sector to good health. That happened in the Great Depression of the 1930s and many post-World War II recessions, he argues. So Mussa is pitting his reading of history versus the conventional wisdom. Time will tell who got it right.