Map of OECD Members. Source: Google Images
Why should we trust them? Economists in think tanks the world over got it wrong before this crisis. Now, many of them point to the “Black Swan” event, the large-impact, hard-to-predict rare event, to explain away their flawed work and keep their jobs. Yet the data were there – reversion of U.S. households to negative savings, prolonged run-up in real estate prices, irresponsible monetary policy based on outmoded, ideological ideas (yes, that means you, Sir Alan).
The OECD semi-annual economic outlook was released today, and they revised up their projections for the first time in two years. The OECD is forecasting a bottoming of the global economy this year, but a weak and fragile recovery. The report is useful in explaining the past, forecasting the near-future (i.e. 2009), and in detailing the challenges ahead. However, as in the past, these economists base their forecasts on a continuation of current trends, instead of using intuitive thinking to discover future drivers of economic growth.
I’m reminded of a discussion I had with an economist at a rating agency in January 2008, when I suggested his forecasts for U.S. growth be revised way down due to the unknown impact of the painful adjustment of the abysmal household savings rate. Equipped with his fancy charts and always a prisoner of his numbers (which economists usually are), he affirmed that there was no evidence in the figures to suggest things would be worse than he forecast. They turned out to be much worse and exactly for the reason that should have been clear – the painful adjustment from the run-up in household debt we saw this decade. What’s more, institutions with economists on staff, including the OECD but especially for-profit firms with money to lose, cannot be seen as putting a drag on market confidence with pessimistic forecasts. It is only the odd gadfly analyst at a no-name institution that is willing to take such a risk (I’m reminded of a small analytical firm called CreditSights).
Don’t get me wrong. We can’t base our forecasts on fancy. We have to look to the numbers. But, the really good analysts, as opposed to the legions of well-educated ones whose salaries waste too much of our GDP, make intuitive leaps and see the problems and opportunities ahead.
The OECD report forecasts growth in OECD countries of negative 4.1% this year, with inflation of 0.6%. Growth in 2010 is forecast to be a sluggish 0.7% with inflation still under 1%. These inflation rates suggest that the bond market today, with U.S. long rates at 3.7%, is wrong. The real long rate (after subtracting inflation) thus stands at about 3%, while real short rates are zero or negative. The bond market is worried about all the borrowing governments are doing and that fiscal deficits will not be trimmed in the medium term. This pushes up long rates.
Unemployment will remain high through next year, according to the OECD, at above 10% in most major economies. Disturbingly, world trade should contract this year by 16%, still below the nearly one-third contraction in the thirties, which was in part caused by protectionism. The OECD rightly warns against the latter. I hope Democrats in Congress are listening.
The U.S. current account deficit, an indicator of U.S. borrowing from the rest of the world, will be more than halved in 2009, a positive development. But it is still negative, and as such, does not reduce the enormous stock of debt U.S. residents (government and the private sector) have to non-residents. At over 250% of broad exports, America’s net debt to foreigners is astronomical, only exceeded among sizable economies by Spain’s. This suggests that the economic adjustment in the U.S. could be prolonged. Economists underestimated this drag on the U.S. economy, with such guiding lights as Ben Bernanke arguing current account deficits were due to a global savings glut and superior U.S. investment returns, not to profligacy at home.
The OECD warns against governments failing to balance the fiscal books in the medium term, but also against consolidating too soon, which could derail the recovery. The OECD advocates ensuring that spending plans put in place by the stimulus package are implemented in order to support recovery. The flawed reasoning here is as follows: the most powerful impulse to the economy provided by fiscal and monetary stimulus is the jolt to market confidence it provides. The government cannot hold up a sagging economy on its own forever, without becoming insolvent. If they tried to, they’d be the Soviet Union. The best a government can do is to announce programs to stimulate the economy and clean up the banks, and hope confidence within the private sector is thus restored. This confidence boost causes firms and consumers to spend, and that is the only sustainable way to grow. By spending an additional 10% of GDP in one year, the government can add a couple of points to one year’s GDP growth rate. But in so doing, the government’s debt-to-GDP ratio rises — in the U.S. to a worrisome 85% of GDP this year. The ideal situation is: the government announces a plan; consumers and businesses become so happy as a result that they spend and invest, driving the economy higher; this way the government avoids much of its announced stimulus outlays during later years (or even months), safeguarding its creditworthiness. Remember, S&P recently put the U.K.’s AAA rating on a Negative Outlook (see previous post).
Agreed — the fiscal stimulus should not be withdrawn too soon. Further, an announcement soon of a medium-term deficit reduction strategy would calm markets – thereby allowing long rates to fall. However, the OECD in its report does not sound the alarm bells loud enough about the lack of indications that governments will consolidate over the medium term. With Democrats tucking all their pet ideological projects, such as health care reform, into the current legislative calendar and not yet announcing a medium-term strategy, long bond rates remain high, making it difficult for private borrowers to raise and invest funds.
The OECD may underestimate the prospects for a double-dip recession as well. The degree of balance sheet repair needed at banks may be more extensive than markets and analysts expect right now. And, once the fiscal stimulus wears off, if private agents don’t step in, we’re back where we were in late 2008, except with a staggering government debt.
If this latter scenario obtains, then the OECD’s dismissal of deflation as a risk could prove wrong. Deflation is a worse enemy than inflation. With price deflation, borrowers default en masse. So, lenders refuse to lend and the economy spins downward. Fixing the banks, whose balance sheet impairment hinders the transmission of monetary stimulus, is paramount here. The Fed and other central banks should withdraw liquidity at some point, but not soon. Better to withdraw the fiscal stimulus earlier, in order to prevent a deterioration in sovereign creditworthiness, allowing long rates to fall, which in turn reinforces the monetary stimulus.
In terms of reforming the regulatory framework, the OECD applauds; however, the Obama administration has not seized the opportunity to cut the U.S.’s overlapping and inefficient regulatory system, in which competing agencies – the Fed, the OCC, the FDIC, state regulators, etc. – compete for scarce resources, pass the buck, defend turf, and inadequately supervise. Sure, the Fed should be strengthened. True, it’s worthwhile to have some bureaucratic competition to keep the Fed honest. But streamlining is needed, and they have decided not to press for any. It seems the kid gloves Obama wears when handling Iran, he uses as well with the financial bureaucracy, members of Congress, and the financial industry.
Interestingly, the OECD forecasts Euro area economies to contract more this year (4.8%) than the U.S. economy and not to grow at all next year. Unemployment is expected to be higher (around 12%) than in the U.S. This looks to be in part due to the reluctance of governments in the region to stimulate their economies as much as was done in the U.S., China, and the U.K. It is also due to their dependence on trade, which has contracted so much, and perhaps to structural rigidities in the labor and product markets.
In any event, the OECD report is useful in highlighting current trends and in pointing out risks and challenges. Take its 2010 forecasts with a huge grain of salt. Use it to make your own intuitive leaps about whether or not the global economy is bottoming out. And, consider that what is needed across the planet includes: medium-term fiscal consolidation plans drawn up and announced right away; scrapping ideological spending initiatives such as health care reform; continued emphasis on cleaning up bank balance sheets; and resisting any calls from the left or the right for trade protectionism. Happy reading…
