US GDP Forecast: Digging Out of A Deep Hole?

In today's NY Times, Paul Krugman took a pessimistic position on the U.S. economy (here). His Op-Ed got the attention of CNBC who compared it to the bullish outlook of Jan Hatzius, Goldman Sachs chief U.S. economist (here). Krugman was arguing that even though the economic indicators might look good, we are still a long way from bringing unemployment down.

If there’s one piece of economic wisdom I hope people will grasp this year, it’s this: Even though we may finally have stopped digging, we’re still near the bottom of a very deep hole.

I'd like to pick a little at the quote above from Krugman's Op-Ed. Are we actually digging out of a hole? Is this the right analogy? It isn't and choosing a better analogy does have implications for future policy responses.
The first graphic above plots U.S. GDP as a function of trends and cycles in the World economy (a model based on trends and cycles in the U.S. economy was a close second in terms of predictive power). The model fits the data pretty well (it was actually estimated from 1950 to Q3 2010 using data from the BEA, here) although it didn't catch the turning point of the global financial crisis.

The second graphic above shows the long-run equilibrium position (the GDP dynamic attractor) predicted by the model for GDP. Notice that the dot-com bubble, usually dated from 1995-2000 (the model doesn't show the bubble starting until 1998), is visible (one step ahead predictions above the equilibrium line) while the subprime mortgage crisis (usually dated from 2007-2010) started to develop in 2004.

In other words, the model does not show the U.S. economy "digging out of a hole" but rather returning to a more sustainable growth path based on growth in the world economy. There was a period of "overshoot" (the hole?) between mid-2009 and mid-2010, but the overshoot was in response to the massive bubble that developed after 2005. The Economic Stimulus Act of 2008 and the American Recovery and Reinvestment Act of 2009 may have prevented the overshoot from being larger, but that counterfactual is clearly debatable (even Paul Krugman thinks the stimulus was too small to have made a difference).
For the future, the model definitely predicts that GDP has recovered (the dotted lines in the graphic above are the 98% bootstrap prediction intervals) with a high degree of confidence. Notice that the model shows the recession ending in June of 2009, exactly the date picked by NBER's Business Cycle Dating Committee.

Although the last graphic above looks a little like a "hole we were digging out of", the model shows the bubble developing over a longer period of time starting in 2005. And, if it's possible to identify an economic bubble, it's theoretically possible to control it's growth before it pops. Rather than more stimulus right now, more regulation back in 2005 and going forward would have been the better solution (everyone seems to agree that regulation slows things down). Dealing with unemployment is another matter and will have to be covered in another post.

NOTE: You can compare my forecast with one produced by the Financial Forecast Center (here). The forecasts are very similar although the Financial Forecast Center does not provide prediction intervals or any information about historical predictions.