Forecast I -- We begin the extension of the Demand Side forecast

The low-tech forecast from Demand Side

All the high-flying forecast models have broken down. The Demand Side forecast does better than the Bull Chips.

Not by brilliance, but because we are looking in the right direction.

It is not that there is any particular sophistication in our forecast that it has done so well in difficult times, it is just that the forecast adopts the demand side perspective.

We'll get to the details on the next podcast. Today the theory.

Waiting for profits to increase before the economy can turn around, a canard repeated by last week's Idiot of the Week, is ass-backwards. The prospect of profit must increase, not the fact of profit.

The difference is the crucial difference.

Prospect is forward-looking and involves investment. Entrepreneurs identify a need and fill it. The investment is important. it is the beginning of the business cycle, such as it exists.

The fact of profit means the investment is paying off, not that any new investment is required. In fact, companies habitually maintain this profit by discouraging investment from competitors by one means or another. Continued profits may mean a good investment has been made in the past, but it may equally mean a protected industry or the aging of the business cycle.

When we use the word investment, we are not referring to buying stocks, but in real investment. Equities and debt issues from companies do not necessarily mean a new plant or better mousetrap -- or more jobs. They are purchases of existing investment and may very well be made for defensive purposes or to take advantage of a market advantage or some other reason. Financial investments, in particular, are -- as we have discovered to our dismay -- not jobs-producing investment.

We use the concept of business cycle not because we put much stock in it as a prime descriptor of what is going on, but because it is familiar. The concept is much more useful when applied to segments of the economy, the sectors, than it is when applied to the economy as a whole. The entrepreneur is always looking forward, hence there is no particular reason for demand to fade unless the profits portion is too large or concentrated in cohorts that do not spend or invest. Such unbalanced profits distribution simply drains the multiplier.

The past two recessions, for example, were brought on by speculative financial bubbles. This is not a business cycle. It is demand alternately stimulated and crushed by perceptions of wealth, as paper values of stocks and houses rise and fall. It may stimulate investment, but because these perceptions are in a bubble, that investment is inevitably distorted.

One might argue that the investment boom of the late 1990s actually ameliorated the downturn in the 2000's. The real improvements in productivity reducing, perhaps, the decline in perceived wealth. Be that as it may, and it is only speculation:

Demand creates the prospect of profit. But what creates demand? One might foresee that a water shortage will increase the demand for water, and so invest in that commodity. But it must be effective demand. You will not make a profit if people cannot create effective market demand by having the income to purchase.

In our current case, what creates demand is government spending and investment, and its translation into private investment.

One of the great calamities afflicting young economists is segregating C + I + G + NX. Consumption plus investment plus government spending plus net exports. On one hand, it is an accurate description of output, since it covers all the bases. On the other hand, it is simply a labeling exercise which often gets its tags wrong. C includes consumer durables, some education and health care. G includes a lot of education, health care, infrastructure spending and activities such as national defense. All of this might be better thought of as investment in a real form. The I includes only investment by businesses and residential housing. Business inventory may include chewing gum.

Not to beat this horse too long, but the return on education per dollar is about six times that of residential investment,

What creates demand? Investment. Government spending. But it is also released by economic security.

You heard our simple modeling of the various stimulus packages where we highlighted the falling consumption function. The consumption function is the proportion of new income that is spent. In good times, with stable prospects, more of one's income may be spent. In bad times, with uncertain prospects, the tendency is to save. You can see the savings rate spiking right now. Private pullback has more than offset public stimulus. We'll have a comment on the savings rate and the flagellation of the American consumer in an upcoming podcast.

But let's walk around this point a bit.

What is so important economically about the health care fix? It will create security and return confidence in consumers. So serious has been the body blow to the balance sheet of households that confidence will not return without a tangible reason. Universal health care can be one reason. Secondarily it will reduce the many types of burdens of profit-first health care delivery on the budgets of households, government and business.

What destroys demand? Withdrawal of investment and government spending -- and a falling consumption function.

All other things equal, one would use government spending to balance a drop in investment spending such as we have seen since 2007 with the drop in residential and business investment. This has not happened. Not only has there been the pull-back in the household and business sector we noted above, but the contraction in state and local government spending has also offset much of the federal expansion. The financial collapse and credit crunch piled on an enormous subtraction in investment and employment far above what might have occurred in the expiration of a housing bubble absent the blunders in securitization, mortgage innovation and derivatives.

We could go on.

But to the forecast.

As we've said, our baseline forecast assumes policy advances at the federal level in three areas:

(a) Removing the zombie banks from the economic field and reforming the financial sector,

(b) Fiscal stimulus, and

(c) Improvements in social insurance and homeowners' assistance.

We did not mention homeowners assistance this time, until now, but it is important not only to stabilize the consumption function but also to stabilize the housing market. These clearly are not in place to the level we imagined, but neither have policymakers exhausted their allotment of time. The response may come as the facts make themselves more clear.

Prospects going forward are uncertain to the degree that we are going to break out the forecast into optimistic, baseline, and pessimistic scenarios. The differences are based entirely on government policy choices. We recognize that economics is a science of human behavior. The behavior of millions aggregated is, however, more predictable than that of a few in government or powerful corporations that may have idiosyncratic incentives.

You've heard some of the assumptions for the baseline. We'll go into the details, including the numbers in the next podcast.