(photo: Thomas Hawk)

Before moving on with a look at the economy in 2012, I wanted to go back to my forecasts of the economy in 2011. It turns out that the usual suspect economic analysts predicted a “self-sustaining expansion” for 2011. The leading forecasters predicted annualized growth between 3% and 4.5% for the year. I was skeptical.

If government isn’t going to drive a recovery, where will the improvement come from? Businesses are generating big profits, but so far they have not translated those into the kind of hiring that would bring down the unemployment rate. Housing, which traditionally leads the way to recovery, remains a mess. There’s still a yawning gap between existing home sales and new home sales, and with a large shadow inventory I don’t see much home construction getting done in 2011. The impact of the foreclosure fraud crisis depends on where you live, but either the banks are able to fast-track foreclosures, which is terribly destructive to local economies, or the foreclosure market has basically shut down. Without an actual resolution, the latter just creates mass confusion in the market and hurts the economy as well. Banks are resisting the kind of solution which would break the logjam in housing, stabilize prices and lead the way out. As a result their balance sheets remain shaky, their risk remains high, and lending suffers as a result.

These problems never remedied themselves and the economy never got untracked. Only in the fourth quarter will we even approach 3% growth. The green shoots were a mirage. The only reason unemployment stands at 8.6% is because of a drop in the labor force, artificially making it look like less people are out of work.

Analysts have a lot of excuses for this: the turmoil of the Arab spring, a series of natural disasters including the tsunami in Japan, the crisis in Europe. But the Arab spring remains an issue. The Iranian threat to close the Strait of Hormuz shows that the Middle East remains unsettled. Europe has not found a sustainable solution, and in fact the continent is heading into recession, which will have an impact on US exports. Natural disasters in a climate-changed world will happen with increasing frequency. The “unexpected factors” are not so unexpected. [cont’d.]

I bring this up not to bolster my own forecasting credentials, but because we’re in the midst of a very similar conversation right now. The relatively good 4th quarter and the passage of a short-term extension of unemployment benefits and the payroll tax cut (with the expectations of a longer-term passage down the road) have led analysts to make predictions of economic performance in the coming year. Here’s a sample from David Wessel:

For the past year and half, the U.S. has been caught in a tug of war. On one side is the economy’s natural resilience. On the other are the long-lasting effects of a burst credit bubble and some bad luck—the oil-price spike provoked by the Arab Spring, the supply-chain disruption following Japan’s earthquake. At the end of 2010, the economy’s resilience was winning. In 2011, it gave ground.

The latest incoming data are encouraging. Initial claims for unemployment compensation, one of the better early-warning signs, have fallen to their lowest level in 3½ years. Consumers say jobs are a little easier to find, another useful indicator. Housing starts and home sales are up. Inventories are lean. And, for what it’s worth, the stock market has bounced back in the past month.

This could be the start of the much-hoped-for virtuous circle. The job market improves. Consumers have more income. Spirits and, more important, spending perk up. Meanwhile, weakening economies abroad keep commodity prices down and limit inflation in the U.S. With mortgage rates low and consumer finances improving, home prices turn up at last. Businesses, flush with cash, expand and hire more readily, offsetting the retrenchment by governments.

Wessel tempers this later in the piece, but that’s generally the belief. The leading indicators are positive, government is generally staying out of the way of the recovery in 2012 by extending any fiscal measures, and a positive feedback loop could take hold.

As in 2011, I wish I could believe that. But we’ve seen credible speculation that the relative good times in the fourth quarter came from temporary factors, like inventory restocking and backlogged orders from the Japanese tsunami. The payroll tax/UI extension for the rest of the year has not been locked in just yet, and could expire at the end of the 1st quarter. The FY2012 budget is done, but the FY2013 budget calls for far deeper cuts, and that needs to get resolved right in the heart of the Presidential election, at the end of September.

And I think analysts are most confused with respect to housing. Apparently hedge funds are starting to bet big on housing, and often they have at least some logic behind them. But we’ve heard about a bottom in housing for the last four years. I’ve seen the charts about the collapse in home building relative to population, and how people have to have somewhere to live. But without ready cash, I don’t see a lot of household formation available. And with prices still falling – the October Case-Shiller numbers showed that – foreclosures and underwater homes will still be a problem, one that we don’t have the tools to solve like increased jobs or wages. In fact, first-time jobless claims went back up last week.

So I don’t think growth will rebound, certainly not to a level that would lead to a rapid reduction in the unemployment rate. In fact, if the economy improves and more people return to the labor force, the result could be an uptick in that rate. We’re still moving at stall speed, not enough to return growth to trend, though not so slow to sink into recession. And then a European bank could fail and cause ripple effects that put us right back into the pit. We have the tools to solve this crisis, but the best we can hope for in Washington is that they don’t do anything actively harmful. They refuse to take the steps that would get us out of the mess. A lost decade is not determined by the fact of a financial crisis; it’s determined by the policy failures in reaction to it.