A Forecast With Hope Built In

In the weeks just before President Obama took office, his economic advisers made a mistake. They got a little carried away with hope.

Treasury Secretary Timothy Geithner, Council of Economic Advisers Chair Christina Romer, and National Economic Council Chair Lawrence Summers.
Treasury Secretary Timothy Geithner, Council of Economic Advisers Chair Christina Romer, and National Economic Council Chair Lawrence Summers.

To make the case for a big stimulus package, they released their economic forecast for the next few years. Without the stimulus, they saw the unemployment rate — then 7.2 percent — rising above 8 percent in 2009 and peaking at 9 percent next year. With the stimulus, the advisers said, unemployment would probably peak at 8 percent late this year.

We now know that this forecast was terribly optimistic. The jobless rate has already reached 9.4 percent. On Thursday, the Labor Department will announce the latest number, for June, and forecasters are expecting it to rise further. In concrete terms, the difference between the situation that the Obama advisers predicted and the one that has come to pass is about 2.5 million jobs. It’s as if every worker in the city of Los Angeles received an unexpected layoff notice.

There are two possible explanations that the administration was so wrong. And sorting through them matters a great deal, because they point in opposite policy directions.

The first explanation is that the economy has deteriorated because the stimulus package failed. Some critics say that stimulus just doesn’t work, while others argue that this particular package was too small or too badly constructed to make a difference.

The second answer is that the economy has deteriorated in spite of the stimulus. In other words, the patient is not as sick as he would have been without the medicine he received. But he is a lot sicker than doctors realized when they prescribed it.

To me, the evidence is fairly compelling that the second answer is the right one. The stimulus package does seem to have helped. But its impact has been minor — so far — compared with the harshness of the Great Recession.

Unfortunately, the administration’s rose-colored forecast has muddied this picture. So if at some point this year or next the White House decides that the economy needs more stimulus, skeptics will surely brandish that old forecast.

Worst of all, the economy really may need more help.

There is no ironclad way to judge the stimulus, because we can’t rerun the last six months in an alternate universe. But you can get a pretty good sense by looking at the size of the gap between where the economy is today and where the administration thought it would be: those 2.5 million jobs that would still exist if the forecast had been right.

This gap is just far too large to be explained by the stimulus. The plan that Mr. Obama signed definitely has its flaws. It spends money more slowly than is ideal and spends some of it on projects of little long-term value. But no stimulus package could have come close to preventing 2.5 million job losses over six months.

For starters, a stimulus package doesn’t affect the job market immediately because most employers don’t hire or fire workers as soon as they sense their business shifting. That’s why economists refer to employment as a lagging indicator.

When private economists began analyzing various stimulus proposals in January, they said that none would have a major effect on the jobless rate until the end of the year. By June, the effect would be only a few tenths of a percentage point, which translates into several hundred thousand jobs.

The stimulus that passed may in fact be having an impact of roughly this scale. Consumer spending, after plummeting late last year, is up slightly this year, despite a continuing rise in the savings rate. This combination suggests that spending would still be falling if not for the tax cuts in the stimulus.

“Early results,” says Mark Zandi, chief economist of Moody’s Economy.com, “suggest the stimulus is performing close to expectations.” Obviously, though, the economy is not performing close to expectations.

It’s not fair to expect Mr. Obama’s economists to be clairvoyant. But they did make one avoidable mistake that led directly to their overoptimism. They relied on the same forecasting models that had completely failed to see the crisis coming.

These models, which are also used by Wall Street and various research firms, do a decent job most of the time. But they are notoriously bad at forecasting turning points because they are based on an assumption that the recent past will more or less repeat itself.

Clearly, recent economic history is not going to repeat itself. It included two huge asset bubbles, first in stocks and then in real estate. The models came to treat those bubbles — and the additional consumer spending they caused — as the new normal. When asset prices began falling, the models couldn’t keep up, with either the pace of declines or the economic damage they were causing.

“All sorts of relationships got completely out of whack, and models couldn’t cope with that,” says Joshua Shapiro, an economist at MFR, a research firm. MFR did not take the models too literally and was one of the few firms to have been appropriately pessimistic. The Obama administration believed the models.

And what do these models say today? They are forecasting that the recession will end in the next few months. Administration officials aren’t quite so specific, but they are in a similar place.

Christina Romer, a senior Obama economist, argues that businesses that have spent the last few months drawing down their warehouse inventories will eventually need to rebuild them. Lawrence Summers, the top economics adviser, says that many consumers who have been delaying the purchase of a new car will eventually take the plunge. The government, meanwhile, will be pumping out close to $30 billion in stimulus money every month for months to come.

A big headline across the front page of Monday’s Financial Times summed up the position: “Romer upbeat on economy.”

It’s an entirely reasonable prediction. Yet it’s hard not to look back on the last six months and worry that the administration is still underestimating the severity of the situation.

Many consumers may not rush back to their old buying habits. Mr. Shapiro points out that household debt, relative to assets, remains far higher than historically normal. “It’s going to be a very long slog,” he predicts. That would certainly be consistent with the aftermath of other financial crises.

The larger point is that, even if the optimists are right this time, the economy isn’t going to feel remotely healthy anytime soon. Since jobs (and incomes) are a lagging indicator, the unemployment rate will probably surpass 10 percent this year and remain above 9 percent well into next year. Long after the experts say the economy has turned, it is going to feel pretty bad.

Another stimulus package may soften the blow, but it can’t prevent most of the pain. The problems are too big. So it would make sense for everyone — the administration and the rest of us — to have a sober view of what might lie ahead.