Optimists--Or Just Dreamers?

We need to avoid the nostalgia factor--a longing for the late lamented economic boom that clouds our vision and corrodes our judgment. People understandably yearn to return to the good old days of the late 1990s. It won't happen any time soon, and those who suggest it might are engaging in wishful thinking. They're telling us what we want to hear. There's a lot of that these days. Beginning a new year, when economic forecasts are flying furiously, it's important to grasp their limits.

If you believe the conventional wisdom--which seems reflected in the stock market's recent rise--the recession is almost over. The Blue Chip Economic Indicators, a newsletter, surveys 53 forecasters and finds that about 70 percent think the recession will end no later than April. The latest average forecast predicts 0.4 percent growth in the gross domestic product (the economy's output) in the present quarter. By the fourth quarter, GDP should expand at a respectable 3.9 percent annual rate. Could happen. But if it does, it will be luck as much as anything else.

Truth be told, most economists don't really understand this peculiar recession especially well. We know this because most of them didn't predict it, which wasn't surprising, because most didn't understand the preceding boom, either. They constantly underestimated its strength and only belatedly recognized that some of its powerful driving forces--extravagant investment in new technologies, widespread stock-market speculation--were not altogether good. Forecasters' recent record has been dismal.

Let's look back. In January 1996, the average Blue Chip forecast was that GDP would increase 2.2 percent that year. The actual increase was 3.6 percent. Here are the January predictions and actual outcomes for the next four years: 1997, 2.3 percent versus 4.4 percent; 1998, 2.5 percent versus 4.3 percent; 1999, 2.4 percent versus 4.1 percent; 2000, 3.6 percent versus 4.1 percent. You might say that these are minor mistakes, just a few percentage points. But the economy usually grows between 2 and 4 percent a year. To have value, a forecast must be closer to the actual numbers. Forecasters were missing GDP growth by as much as 48 percent. (A 2 percent forecast against a 4 percent outcome is a 50 percent underestimate.)

If you didn't understand the boom, why would you better understand the bust? No obvious reason.

A year ago, the Blue Chip consensus saw 2.6 percent GDP growth for 2001. The actual figure will be about 1 percent or maybe less. (The Commerce Department releases the first official estimate on Jan. 30.) But if September 11--something no economist could have predicted--caused the recession, don't forecasters have an excuse? This defense sounds better than it is. Although September 11 worsened the economy, the recession had already started. The National Bureau of Econom-ic Research (a group of academic economists) dates the onset to early spring.

All this suggests that you should treat the present recovery forecasts with skepticism. The standard post-World War II recession has followed a familiar pattern: (a) while the economy is expanding, inflation rises; (b) to dampen inflation, the Federal Reserve increases interest rates; (c) as the economy slows, businesses develop unwanted inventories (excess supplies of unsold goods); (d) to reduce inventories, companies cut production and lay off workers; (e) higher inventories and unemployment cause price and wage increases--a.k.a. inflation--to subside; (f) the Fed then trims interest rates and the economy recovers. The process usually takes less than a year. Since World War II, the average recession has lasted 11 months.

By this schedule, the recession must nearly be over. It started almost a year ago. Time for recovery. Unfortunately, this recession didn't follow the familiar pattern. True, inflation did rise (very slightly) in 1999 and 2000, and the Fed did increase interest rates beginning in mid-1999. But the economy's main problems weren't--and aren't--inflation and excess inventories, which could be speedily remedied.

The economic euphoria of the late 1990s caused consumers to go on a spending spree and businesses to go on an investment binge--and the rest of the world fed off the American boom. Consumers spent by skimping on savings, borrowing heavily or cashing in stock profits. At year-end 2001, consumer debt payments were a near-record 14.3 percent of disposable personal incomes, according to Moody's Investors Service. Similarly, excessive corporate investment has left enormous unused factory capacity. According to the Fed, the surplus is greater than at any time since 1983.

What's now occurring is a period of "payback." Corporate investment dropped during 2001. In early 2000, consumer spending grew at an annual rate of 5.9 percent; by the third quarter of 2001, the gain was a meager 1 percent. This twin retrenchment represents a huge drag on the economy that spills into other sectors. Corporate profits have already plunged. State and local government spending will suffer as tax revenues falter. Nor is the rest of the world helping. Japan is in recession; Europe is in or near one. Argentina just defaulted on its debt; many developing economies are weakening.

It's easy to sympathize with forecasters. So many unfamiliar forces are now tugging at the economy that a coherent outlook is hard, maybe impossible. No one truly knows what will happen--especially, how long it will take consumers and businesses to recover from their recent frenzied spending, and how the economy will react to the Fed's 11 interest-rate cuts in 2001.

But the forecasters crank out their numbers, and there's a tendency to see the recession simply as a brief and unpleasant interruption to unspoiled prosperity. This may be too glib. The central reason economists misinterpreted the 1990s boom was that they assumed that the economy would follow historical patterns. It didn't. If economists repeat their error--and they may be doing just that--then they will be surprised, probably unpleasantly, by the pattern of recession and recovery. And that could be bad news for us all.