January 8 , 2003

This is the time of year when I grade myself on my forecast for the previous year.  Just over a year ago, I mentioned that the recession was lessening and that economic growth should slowly build during 2002.  However, we needed to await 2003 before significant growth returned. 

Most of that sentiment proved to be correct.  Nevertheless, I can only give myself a high C for forecasting this past year.  That fact that many economists did even worse does not soften the sting of that assessment. 

More than a percentage point of economic growth was guaranteed as inventory investment shifted from the largest liquidation in history to modest gains by the end of  2002.  My assumption about low inflation and the creation of more than 2 percentage points of purchasing power was close to the mark.  Also, my assessment that debt would not slow consumer spending because the cost of debt was falling remains very relevant. 

Once again, more than a percentage point of economic growth could have been expected from this improved purchasing power. 

I also expected unemployment to rise through the year, but my assumption of a 6.5 percent rate by yearend was a little high.  Unfortunately, that level probably will be reached, but later in the spring of this year. 

When you add contributions for government, where my concerns about state revenues were well founded, then growth of more than 2.5 percent was in the bag. 

Then where did I err?

First, I assumed that corporations would have some pricing power.  Although I correctly assumed that fixed investment would remain weak through the year, I was hoping for modest profit growth.  In fact, many companies continued to slash prices to preserve market presence.  As a result, balance sheets became shaky and corporate bankruptcies reached record highs. 

Second, I felt that a slowly expanding economy would pick up steam as job losses subsided.  In fact, job growth never was significant and job losses reappeared before the end of the year.  In fact, except for the improved purchasing power of consumers, the inventory investment swing, and government spending (mostly for defense and home security), there was no driving force to economic expansion.  Instead of building, expansion actually stalled in the fall. 

Third, without pricing power, stock prices slumped while interest rates fell sharply.  This allowed much stronger gains in housing and auto sales than I expected, but did nothing to aid the financial health of corporations or the credit available to smaller businesses.  Indeed, corporate officers discovered that it was easier to refinance their houses than to lower the interest charges on their company's assets.

I am still pondering whether these errors were the result of underestimating the adjustment to speculative asset excesses or were another response to poorly timed tax cuts. 

Remember, Ronald Reagan slashed taxes over a three year period beginning in 1981 and witnessed a surge to 10.6 percent unemployed in 1982.  When you know your tax incentives are going to be larger next year, you tend to delay responding to them this year.  A decade long tax reduction as passed by the Bush administration merely prolongs that agony.

What further dampened the response to the Bush tax cuts was the early refund of the new 10 percent tax bracket, which actually diminished tax reductions in 2002.

If the Bush administration wants stronger reactions to its tax cuts, it must bring all those marginal tax rate reductions forward to this year.  That will eliminate any muted response to current reductions because they will be larger later. 

I also continued to over-estimate the importance of interest rate changes to enterprises in the short run.  Part of this is caused by the failure of lower interest rates to lower the finance costs of companies who are struggling to meet sales targets.   In many cases, selling assets and paying down debt is a better strategy than refinancing corporate loans in an economy where falling interest rates reflect the absence of pricing power. 

However, I finally called the dollar's weakness correctly.  It took several months and a stock market reversal, but capital began to flow out of the United States.  Surprisingly, this had minimal impact upon domestic interest rates, probably because of the deteriorating credit worthiness of  U.S. corporations. 

Indeed, that dollar decline probably will allow U.S. producers to begin selling goods abroad and stem the flood of goods into the U.S.  If so, and if we get that acceleration in marginal tax rates, we still might have a good year toward the end of 2003. 

Of course, I must use the current buzz word, geopolitical assumptions, to qualify my assessment.  More terrorism or adverse military activity could change everything.  Indeed, until corporate balance sheets begin to improve, this economic expansion remains very fragile. 


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