I've got something of a reputation as an economic soothsayer. Last March I predicted the economy would slide off a cliff in six months. Six months later, it did. How did I know? I'll get to that later. Now, I'm predicting the economy will start to recover in the second quarter of next year.
First, look at the economic fundamentals -- such as historic ratios of home values to rents and incomes and of stock prices to corporate earnings. At the rate houses and stocks are now dropping, they'll be terrific bargains by the middle of next year. Meanwhile, given how fast business inventories are now dropping, firms will probably start rebuilding by then. Business investments in plants and equipment are now nearing a standstill, so by the third quarter of next year companies will need to replace lots of aging equipment. On the consumer side, the sharp falloff in spending on durables means lots of cars and appliances will begin wearing out by the middle of next year.
You get the point. There's a reason it's called the "business cycle." Contrary to Isaac Newton's law of gravity, what goes down eventually comes up. But how can I be so sure spending will pick up by the second quarter of next year? What if the outlook continues to be so grim that businesses and consumers delay new expenses and investments beyond the point they'd normally revive them? This is where the political cycle comes in. A president's party tends to lose seats in the first midterm elections, but Obama knows he can hold on to his majorities if he handles the economy well. Voters respond to economic trends more than to current levels -- to where the economy is heading rather than to where it is. Regardless of how the economy is doing in the months leading up to the midterm election in November 2010, voters will keep Democratic majorities in the House and Senate if they think the economy is on the mend.
That's why the $787 billion stimulus package was designed like a timed-release cold capsule. Stimulus spending will increase through to the end of 2009 and continue full blast in 2010. Although it's too small to restore the economy to full health by Election Day, the stimulus needs only to give the economy enough momentum by then to convince voters it's on the way to being restored.
But what if the current stimulus is too small even to accomplish this narrower political purpose? Revised figures from the Commerce Department at the end of February showed the economy contracting at a 6.2 percent annualized rate -- much faster than was supposed when the stimulus was introduced. Absent additional government spending, aggregate demand this year and next (consumer spending plus business investment plus exports) could well total $3 trillion less than the economy is capable of producing at full capacity. Even assuming each dollar of stimulus generates $1.50 in new spending as it winds its way through the economy, we're still way short. So in order to give the economy a sufficient boost to be in recovery mode by Election Day, Obama will have to return to Congress, seeking a second stimulus.
Republicans are making exactly the same economic-political calculation. That's why they almost uniformly opposed the original stimulus and will surely seek to block any second one. The last thing they want is an economic recovery by the midterm election. They'd rather voters think the economy is stuck and that Obama's policies have failed. That way, they can turn the midterms into a referendum on Obama, just the way Newt Gingrich turned the 1994 midterms into a referendum on Clinton. That means that if Obama is to win a second stimulus, he'll be depending on one or two Republican votes in the Senate. But remember the Maine: That state's two senators backed Obama before and will do it again.
The wild card is the mammoth bailouts of Wall Street and the Big Three, which most Americans almost uniformly oppose. Congressional Republicans claim to be outraged -- outraged! -- as well. So far, Obama has been treading a fine line between criticizing the bailees and still giving them what they want. But if he returns to Congress seeking more bailout money, he faces the twofold risk of not getting it (many Democrats are equally outraged) and appearing hypocritical. The bailouts are also requiring more money from foreign lenders, mostly China and Japan, which increases the risk of higher interest rates later next year. Higher rates could choke off any recovery. But knowing the political cycle, the administration will attempt rapid triage -- let healthy banks fend for themselves, close failing ones, and demand equity in bailed out banks and automakers. If Obama moves fast enough, voters will begin to see an increase in the value of their involuntary investments by the second quarter of 2010.
Hence, my prediction for the recovery. And remember how perfectly I predicted the meltdown. Full disclosure: I had been making the same prediction -- that the economy would fall off a cliff in six months -- for five years.