Chicago Booth Business Forecast 2010

Business Investment Will Drive 2010 Recovery

Real U.S. GDP will grow by 4 percent in 2010 and by even more – about 5 percent – from fourth quarter 2009 to fourth quarter 2010, said Michael Mussa, AM ’70, PhD ’74, senior fellow at the Peterson Institute for Economics. “The facts belie the gloom of most forecasts earlier this year that the recession would last into 2010,” Mussa said during the 2010 Business Forecast at The Waldorf Astoria in New York on December 3.

Of the four main components of GDP, gross private domestic investment will be the main driver of U.S. recovery, he said. “Business investment, as a whole, will add about as much to GDP as the rise of consumption,” Mussa said. Among the four sub-components of private domestic investment he described were:

* Inventory investment, which shrank by $160 billion in real terms in mid-2009, will grow to at least “modestly positive” levels by the end of 2010. “This will provide an important kick to GDP growth,” Mussa said.
* Residential investment, which declined 55 percent in spring 2009 from its 2005 peak, will increase by 33 percent of that gap. “That’s about as well as we’ve done in recoveries from other recessions,” he said.
* Business investment in plants and equipment will recover about half of its 22 percent drop during the recession.
* Investment in nonresidential structures, which only started to decline in mid-2008, will continue to fall during 2010 and show slight, if any recovery, before year’s end.

Randall Kroszner, Norman R. Bobins Professor of Economics and former governor of the Federal Reserve Board, shared Mussa’s optimism for 2010, but tempered his projection for real GDP growth to 3.4 percent. “Overall in 2010 we will have reasonably strong recovery,” Kroszner said. “But in 2011 and 2012, watch out. That’s because much of the recovery is based on stimulus from the fiscal side and from the monetary side.”

The government will create some jobs, but the key will be to focus not on total payroll employment, but on payroll employment in the private sector, Kroszner said. “You want to look at the self-sustaining recovery in the private sector, not just government actions that are explicit stimulus or that are effectively stimulus, such as the census that will be conducted early next year,” he said.

The main reason recovery will occur in 2010 is very strong monetary and fiscal stimulus, Kroszner said. Since he left the Fed in January, the nominal interest rate of 0 to .25 percent has become more “stimulative” because a return to typical inflation expectations has lowered the real interest rate by 2 to 3 percent, and because risk spreads have declined, he said.

While Congress considers giving the General Accountability Office authority to review the Federal Reserve’s monetary policy decisions, economists know the Fed’s independence is extremely important for managing long term inflation and the economy, said Erik Hurst, V. Duane Rath Professor of Economics and Neubauer Family Faculty Fellow. “There’s an extremely large body of evidence to support this,” Hurst said. “This is not just a couple of guys sitting in an ivory tower making this up.”

Research comparing the independence of central banks with average inflation rates from the mid-1950s to the mid-1980s clearly illustrates this connection, he said. “The independence of the central bank is a measure of how much control a congress or president has on a monetary authority,” Hurst said. “The more independent the central bank, the lower long-term inflation rates are in the economy. The more congresses and presidents control the monetary authority, the more you tend to get inflation occurring in the long run.”

Hurst warned that economic uncertainty – a “chicken and the egg” situation in which consumers and businesses withhold spending until the economy recovers and vice versa – fuels delays in recovery. “You might get less robust recoveries than in other periods of time because you’re still waiting for that uncertainty to be resolved somehow,” he said.

Nominal housing prices have begun to stabilize, but real housing prices will continue to drop for a few years, Hurst said. “This is predicted in the same statistical model I used last year showing that housing booms are always followed by housing busts,” he said. “The model predicted that if prices went up by 50 percent, they would drop by 15 to 20 percent in the first two years after they started falling. Then they stabilize in nominal terms, but then are eroded in real terms for about two years after the initial decline.”

Phil Rockrohr

Read what prognosticators said at the Business Forecast in Chicago.