A few weeks ago, I participated in a panel discussion about why the world economy has been performing poorly. Below are my opening remarks, which drew heavily on CBO’s reports What Accounts for the Slow Growth of the Economy After the Recession? and The Budget and Economic Outlook: Fiscal Years 2013 to 2023, followed by some additional comments.
The most visible and costly economic problem in this country today is the large number of people who cannot find jobs. According to our analysis, the primary cause of that problem is a shortfall in the demand for goods and services relative to the productive capacity of the economy, and the primary reason why demand is weak is the long shadow of the housing bubble and financial crisis. Let me explain briefly.
The U.S. unemployment rate has now been higher than 7½ percent for four years, the longest such period in 70 years. The situation is even more striking if one adjusts for people who have become discouraged about finding work and stopped looking and for people who are working part-time but want to work full-time.
Unemployment is elevated partly because of expanded unemployment benefits and structural factors like mismatches between businesses’ needs and workers’ skills. However, the weak growth of wages, as well as extensive job losses in sectors that are not experiencing big structural changes, imply that most of the excess unemployment arises from a lack of demand for workers by businesses that are suffering from a lack of demand for their products.
The key question is why demand has stayed so weak for so long.
- The Housing Bubble and Financial Crisis. There are various factors, of course, but in our assessment, the most important one is the housing bubble and subsequent financial crisis. The extent of overbuilding during the boom and a sharp tightening in standards for obtaining mortgages have pushed residential construction to a very low level—about 2 percent of GDP less than usual. At the same time, household net worth fell by one-quarter—more than $16 trillion. By standard estimates, that loss in wealth would reduce consumer spending by 3 percent to 4 percent of GDP. Consumer spending has also been restrained by tighter credit and households’ efforts to deleverage. And there are other channels through which the financial situation has reduced demand as well.
- Monetary Policy. What about economic policy? We think it has had mixed effects on the demand for goods and services. Monetary policy has responded vigorously since 2007. But the Federal Reserve has faced significant limitations. One is that nominal interest rates cannot fall below zero. Another is that the economy has been less responsive than usual to low interest rates because of the oversupply of homes, the desire of households to deleverage, and credit restraints imposed by lenders.
- Fiscal Policy. Federal fiscal policy also responded vigorously at first. But the effects of the spending increases and tax cuts in the 2009 Recovery Act have been fading now for almost three years, and other stimulative measures have expired. The combined effect of the deliberate policy choices and the automatic stabilizers has been to reduce the deficit from 10 percent of GDP in 2009 to about 5 percent this year. That is the most abrupt fiscal tightening since the end of World War II, and our analysis implies that it is slowing economic growth. Moreover, uncertainty about fiscal policy has been unusually high, owing to the surge in federal debt, the scheduled expiration of key tax provisions, and the ongoing debate about how to put debt on a sustainable path. That uncertainty is also probably dampening growth, although we do not know by how much.
- Regulatory Policy. Federal regulatory policy has created significant uncertainty as well. The health care and financial sectors have seen major legislation, for which the detailed rules and ultimate impact are quite unclear. In addition, government rules related to energy and the environment are in substantial flux. We think this uncertainty is also dampening growth, although again we do not know by how much.
To be sure, CBO’s economic forecasts over the past few years did not foresee that the housing bubble and financial crisis would cast such a long shadow. We had anticipated a recovery that was slower than earlier U.S. recessions, but the reality has been even worse. That error may suggest that we do not understand the factors at work. We think it is much more likely, though, that we underestimated the potency of those factors. Researchers who have carefully studied the historical record of housing bubbles and financial crises have been warning people since 2007 that working off an excessive housing stock, improving balance sheets, restoring credit, and regaining confidence generally take a long time.
At this point, we think an upswing in housing construction, rising real estate and stock prices, and increasing availability of credit will help to spur a virtuous circle of faster growth in employment, income, consumer spending, and business investment over the next few years. Still, given the restraint from federal fiscal policy and the size of the hole we’re in, we think it will take four more years to get back close to full employment.
I should add here that our report on the slow recovery emphasized a number of points that I did not have time to include in my remarks on the panel. One key point from the report is that the productive capacity of the economy (what economists call “potential GDP”) has grown more slowly in this recovery than in previous ones, largely owing to long-term trends such as demographic changes. I did not cover that point in my remarks because much of the distress and dislocation associated with the recession and slow recovery—in particular, most of the run-up in the unemployment rate—stems from the shortfall of actual output relative to the economy’s productive capacity.
Another important point from our report that I did not discuss on the panel is the weak growth since the summer of 2010 in purchases of goods and services by state and local governments (following a period of strong growth in such purchases). If one compares the growth of each of the major components of GDP between the current recovery and the average of preceding recoveries, a shortfall in state and local government purchases represents the largest portion of the unusual weakness in growth of GDP relative to potential GDP. I did not cover that point in my remarks because the weak growth in such purchases stems largely from other factors that I did mention; in particular, state and local government purchases have been restrained by low tax revenues (owing importantly to the drop in real estate values), tight credit markets (which probably held back borrowing for construction projects), and the winding down of the increase in federal grants to states and localities under the Recovery Act.