July
2011

Vol. 11 - No. 1


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ECONOMY


 

Economic Models: In a Funk

BY PETER G. HALL

EDC Vice-President and Chief Economist

 

If market volatility gives economic models a headache, then they have a whopping migraine at the moment. Critically dependent on past trends, models are now having to absorb the mega-changes of the last growth cycle, and so far, their record is sketchy. What are these model-rocking changes?

Technology grew exponentially in the last cycle, revolutionizing business processes and setting in motion the equally exponential explosion of globalized trade and investment. This has lifted nations that were isolated into the mainstream, shifting economic power and stoking demand for resources.

Growth was extended. The last growth cycle was a marvel. Lasting 16 years, it was twice the length of a normal cycle, convincing many that we had achieved a recession-proof ‘new normal’.

Excesses were enormous. The protracted growth cycle created wealth and spurred confidence enough to get Western consumers spending well beyond their means en masse, a frenzy that characterized the final five years of the cycle. Businesses invested to keep pace with this excessive consumption, and in a globalizing world, these excesses were exported – everywhere.

Recession revealed the extent of these excesses. This was no ordinary correction, but the biggest disruption to economic activity in over 60 years. Regular recessions are frightening enough, but this one caused confidence to implode. What fed the ensuing panic was the very length of the growth cycle itself. Over this period many entered the labour force with little, if any, experience of ‘down’ – and therefore few tools or mechanisms for coping with or strategizing around recession.

The response? Public stimulus, on a scale never before seen. Bereft of private-sector solutions, we collectively turned to our governments, and they did not disappoint. Together they fashioned a swift, significant and synchronized package of spending, taxation and interest rate measures that had a marked effect on global growth in the six months following the summer of 2009. The measures were so effective that many believed they had kicked off the new growth cycle. But they were short-lived.

The current change may well be the most challenging. The effects of stimulus wore off before the colossal excesses were fully absorbed, ushering us into a perplexing phase: the flat zone. We have been here for about a year now, and will be for a few more months until demand and supply conditions become more balanced. It’s a difficult phase because we are naturally wired for growth; flat performance feeds uncertainty, and has created an appetite for high-frequency indications of an economic turn for the better. Overreactions have produced the unusual volatility we now see.

These changes will continue to have an influence on the near-term outlook. Models will be challenged by a key feature of the future: the extended withdrawal of fiscal and monetary stimulus, and its effects on real economic activity. Many wonder if we will ever get back to what we used to consider normal.

The bottom line? Economic models are not broken; they are just having a hard time adjusting to new economic realities. In time, the models will be recalibrated, soothing the headache. By then, we will be back to the business of growth, where model misfires matter less.

 

The views expressed here are those of the author, and not necessarily of Export Development Canada.

©2009 EDC

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