Monday, April 06, 2009

Economic Snap-back Late This Year?

At Kevin Hassett, director of economic-policy studies at the American Enterprise Institute and an adviser to Republican Senator John McCain of Arizona in the 2008 presidential election, writes about the possibility of an economic snap-back at the end of this year. I comment below the star line.

Hassett says (excerpts) - - -

… Back in 1964, [Milton] Friedman speculated that the economy might be thought of as a plucked string: The farther you pull it, the more forcefully it snaps back. That analogy gave the Friedman idea its name, “the plucking model.”

The economy can go down for many reasons. If the world suddenly and permanently demands less of our best product, then a decline today is a harbinger of bad times ahead.

If, however, panic drives everyone to stop buying just about everything, then buying will resume when the panic subsides, and we could easily -- and quickly -- end up back where we started. A panic like that would fit the bill for a Friedman “pluck.”

So if the economy is going to decline, it’s good news to find out that it’s been plucked. That means a snap-back is imminent. …

Hassett explains a snap-back is not a sure thing but provides some help deciding if it is - - -

The hard part, of course, is figuring out whether a given decline is lasting bad news or a temporary pluck.

Until recently, that problem seemed intractable. But over the past few years, econometricians have developed sophisticated models that have solved the problem.

The frontier of this literature has been stretched by a fascinating new working paper by George Washington University’s Tara Sinclair. Sinclair’s model can take the data for an economy and filter out an estimate of whether any plucks occurred. …

Sinclair told me last week that she recently detected something that may be good news for the outlook going forward: “My updated results show that the ‘pluck’ part of the latest recession began in the fourth quarter of 2008.”

That means that the first part of this recession was a lasting adjustment to the collapse of our financial sector, unlikely to reverse itself anytime soon.

On the other hand, the radical declines of the past two quarters are likely transitory, presaging strong quarters to reverse the pluck.

While Sinclair was reluctant to offer a forecast on the outlook, she added that “on average, plucks last just under four quarters.”

With that history as a guide, then, it would seem that the recovery may well be rapid and begin later this year. …

Sinclair’s results also imply that the lateness of the pluck means that permanent damage has been suffered.

When we do recover, we will go back to where we were late last year, with unemployment in the 7 percent range, rather than to the halcyon days [with unemployment in the 5% range]. After that, we can expect a slow and painful drift to full employment.

Sadly, from where we are sitting, 7 percent unemployment looks pretty good, and the news that we have been plucked provides some comfort as more awful news arrives.

Hassett’s entire column’s here.

My comments:

Friedman’s “plucking theory” makes sense. People often overreact in times of stress and uncertainty; and then upon reflection, adopt more rational behavior. We’ve all often seen financial markets snap-back from oversold levels that resulted from panic selling. The 1987 "crash" is a classic example of that.

An important matter Hassett didn’t discuss is the effect on the recovery of current government actions. The massive debt the government is assuming will for certain slow the recovery.

Also, a great deal of risk-taking enterprise will be needed to bring the economy back. But Team Obama’s plans for “taxing the wealthy” and “redistributing wealth” will stifle risk-taking enterprise.

What's your take on all of this?