August 15, 2010
Economic Recovery
The Slowdown in the Economic Recovery-Becker
After falling rather sharply in 2008 and early 2009, American GDP grew at a good pace in the fourth quarter of 2009, but has slowed down during the second quarter of 2010. Unemployment declined to 9.5% from its peak in November 2009 of 10.2%, but has been stuck around its current level for several months. This has led to growing fears of a double dip recession, and to a call for still greater fiscal stimulus. I do not believe that either of these is correct, and that the federal government should be concentrating on providing a good economic environment to encourage businesses and entrepreneurs to invest, hire, improve productivity, and raise longer-term economic growth of the US.
More than 60 years ago, Arthur Burns- former head of the NBER and Chairman of the Fed- and Wesley Mitchell-founder of the NBER- together wrote a classic study of business cycles called "Measuring Business Cycles". They divided business cycles into several stages, such as the economic peak, economic decline, trough, early recovery, late recovery, and then a peak again. They clearly show that business cycles are of uneven length, depth, and severity, and that recoveries do not always proceed smoothly. A recession ends after the trough is passed, but they recognized that during recoveries an economy takes a while before it reaches and then surpasses its earlier peak. So from this perspective, the troubles the American economy is experiencing are not unprecedented, or even unusual.
Nevertheless, I agree with Posner that something is rotten about this recovery from the so-called great recession. The Federal Reserve was slow to react to the financial crisis, but on the whole the Fed's policies since then have been decent, given the many unknowns as it tried various old and new monetary approaches to stem the financial crisis. The financial picture was quite bleak as banks greatly increased their ratio of debt to assets during the boom years, and consumers rapidly expanded their debt to income ratios during these years. So even with the best of responses the recovery probably would have been slow and uneven.
But both the Congress and the administration of President George W. Bush, and especially the Congress and President Obama since his election in 2008 made the main mistakes after the crisis hit. Instead of concentrating mainly on fighting the recession and promoting faster economic growth, the Congress elected in 2008 believed they had a mandate to radically remake the American economy. Aside from repeated attacks on American business, especially banks-some of them deserved- they not only passed various stimulus packages (that did not stimulate much), but also tried to promote a vast legislative program that had nothing to do with fighting the recession. This program was aimed at reengineering the American economy. It included radical changes in the health care system, proposed taxes on carbon emissions by companies, much larger subsidies to alternative sources of energy, such as wind power, proposals to raise taxes on higher income individuals and on corporate profits, and to raise the taxes on capital gains and corporate dividends. It also includes a movement to make anti-trust laws less pro-consumer and more protective of competitors from aggressive and innovative companies. It has as its centerpiece a financial reform bill that was a complicated and a politically driven mixture of sensible reforms, and senseless changes that had little to do with stabilizing the financial architecture, or correcting what was defective in prior regulations.
In previous posts I have laid out some of the major defects in the financial reform act, the healthcare changes, and the unemployment extension bill (see my posts for 7/25 on unemployment, 7/11 on financial reform, and 3/28 on healthcare reforms). To single out a few points of these arguments, I criticized the financial reform bill for, among other things, neglecting to do anything about Fannie Mae and Freddie Mac, two major corporations that were important factors in causing the financial debacle, and for adding an excessive amount of discretion to financial regulators who did not use wisely the discretion they had prior to the crisis. I suggested that a proper unemployment bill would eliminate most unemployment benefits for persons during the first couple of months of their unemployment, and then use the savings from that to extend unemployment benefits during bad times to a year. The most desirable reform of health care should have been to increase the out of pocket share of medical expenses borne by older persons and other individuals with various illnesses- as in countries like Switzerland- but nothing much was done about this in the new law. My detailed criticisms are available in these posts.
Perhaps the new Congress elected after November will try to reverse some of these mistakes. I would like also to see a radical reform of the tax system that returns it to the income tax structure that resulted from the Tax Reform Act of 1986 promoted by President Reagan, and Democrats Senator Bill Bradley and Representative Richard Gephardt. This Act had a maximum personal income tax rate of 28%, except for a "bubble rate" for a few families that hit 33%.
To compensate for any loss in tax revenue from these changes, and to help face the growing debt problem of the US, I would support a value added tax, but only as part of such a comprehensive reform of the tax structure. Value added taxes have many attractive incidence features that can be a valuable way to raise tax revenue in a system with low personal and corporate income taxes. However, VAT taxes also have the potential to be rather easily increased over time without close controls over such increases (see my discussion of VATs in my post on 4/25).
Government spending rose a lot during the last year of the Bush administration, and rose even more so during the year and one half of the Obama administration. Instead of introducing additional stimulus packages and further raising the cost of doing business, Congress and the President should try to create an environment where companies, both large and small, and entrepreneurs are recognized as crucial forces in a dynamic economy. Their activities can help the American economy not only grow out of the economic slowdown, but also raise its economic growth in the future that will greatly improve the well being of future generations, and help meet a dangerous future debt burden.
Our Limping Economic Recovery—Posner
In my first book on the economic crisis (A Failure of Capitalism: The Crisis of '08 and the Descent into Depression), which was completed in February 2009, I argued that the crisis should be called a depression rather than a recession, in part because of the enormous debts that the government was assuming in an effort to overcome the crisis. In my second book (* The Crisis of Capitalist Democracy*), completed in January of this year, I further emphasized the potential long-term adverse consequences of the crisis, and argued that a depression or recession should not be considered over until GDP rejoins its growth path. GDP in real terms is essentially unchanged from what it was two and a half years ago (2007), which means it's roughly 7.5 percent below the growth path (which assumes 3 percent real growth annually), and suggests that it will be years before the economy gets back on it.
I continue to insist that this is the proper way to evaluate an economic crisis. Most journalists and many economists believe that the "recession" as they like to call it (or "Great Recession"—indicative of a mindless proliferation of labels) ended in the third quarter of 2009, when GDP began to increase, after having been flat in 2008 (though falling sharply in the last quarter) and falling in the first half of 2009. But the current performance of the economy, and the likely political and long-term economic consequences, convince me that we are in the midst of a depression, much as we were in 1936 (before a sharp drop in 1937–1938), even though the economy had grown rapidly since the bottom of the depression in 1933.
Why is the economy so sluggish at present? The basic reasons are, I think, first, the reduction in household wealth, due to the fall in housing and common stock values (with the fall in housing values precipitating many foreclosures); second, the high rate of unemployment, underemployment, and reductions in wages and benefits; and third the continued weakness of the banks.
The reduction in household wealth increased the amount of leverage (debt-equity ratio) in consumers' personal finances, and consumers have been deleveraging by increasing their personal savings rate (which has increased from 1.7 percent three years ago to 6.4 percent today), leaving them with less money for consumption. One might think that today's very low interest rates would discourage savings, but the other side of this coin is that savers must increase the amount of their savings in order to obtain the interest income they obtained when interest rates were higher.
With less consumption, there is less production and hence less private investment. These effects are being compounded by the weakness of the labor market from the perspective of workers, which reduces incomes and, by increasing insecurity, increases the propensity to save. And while banks are making good profits because of the very low interest rates at which they can borrow, they continue to hold many sick assets (mainly investments in home and commercial mortgages) on their books, making them reluctant to lend. And anyway loan demand is way down. Most borrowers from banks are either small business or consumers (large businesses tend to borrow by issuing bonds or commercial paper rather than by taking out banks loans), and neither group is in the mood for increasing its indebtedness.
One spur to recovery from a depression is the need to rebuild inventories and replace durable goods that have worn out. This need may explain, along with the stimulus program enacted in February 2009, the growth in GDP that began in the third quarter of 2009 and seems now to be fading. As long as demand for consumption goods is weak, sales will slow after inventories are restocked and worn-out durable goods are replaced. Modern products tend to be highly durable and inventories tend to be much smaller than they used to be, so one cannot expect these standard spurs to economic recovery to have much staying power.
The uncertainties and long-term debt created by the Obama Administration excessively ambitious domestic programs (notably health care and financial regulatory reform) on top of the deficit spending of the Bush years, the plunge in federal tax revenues resulting from the depression-induced decline in taxable income, and uncertainty about which Bush tax cuts will be allowed to expire in the coming year, have impeded private investment. They have done this by exacerbating concerns about what the economic picture will look like both in general and for individual businesses and consumers in the next several years, and perhaps much longer.
A further worry is the volatility of the stock market. The tendency is to view the market's gyrations as reflections of changing estimates of future corporate earnings and of efforts by investors in the market to guess what other investors are likely to do. But when as at present a large fraction of the population has a significant part of its savings invested in the stock market, market volatility increases economic anxieties and thus dampens spending.
As long as private investment and interest rates remain very low, there is a case for further stimulus (deficit spending), especially since federal stimulus spending has been offset to a degree by reductions in state and local government spending. Cautious or fearful consumers save in safe forms, such as insured bank deposits, Treasury bills, or cash. Such savings are inert; under present conditions they do not get translated into productive investment, since banks are reluctant to lend but instead keep most of the deposits they receive in either cash or government securities. The government, to whom no one is afraid to lend, could put all these inert savings to work on infrastructure and other projects that would employ the unemployed.
That is in principle, but because the Obama Administration botched the design, execution, and public relations of the $862 billion stimulus program (President Obama, despite his undoubted eloquence and intelligence, has proved to be a poor explainer of his economic policies), and because of the soaring public debt (to which the stimulus contributed), there is no political stomach for a further stimulus of any consequence.
What is to be done? With Congress in recess and the mid-term elections looming, probably very little. The best hope may be that the President's bipartisan deficit commission (the National Commission on Fiscal Responsibility and Reform) will issue a first-rate report. (Its report is due December 1.) If the commission, chaired by President Clinton's chief of staff, Erskine Bowles, and former Republican Senator Alan Simpson, produces an economically sound and politically palatable program for restoring the nation's long-term fiscal soundness—a program to which far-reaching tax reform will be central—this may alleviate economic uncertainty and encourage more consumption and private investment in the near term.