June 19, 2011
Economic Recovery
The Slow Economic Recovery-Becker
The financial crisis produced the most severe recession since the end of World War II in all the important measures of economic performance, aside from unemployment rates. Unemployment peaked at 10.2% in 2009, whereas it peaked at 10.8% in December 1982 at the end of the deep recession that spanned 1981-82. The recovery from that earlier recession was rapid, as unemployment was down to about 7.5% by 1984, and GDP grew rapidly in 1983 and 1984. By contrast, as Posner indicates, GDP growth has been slow to moderate in the two years following the official end in 2009 of the past recession. Real GDP is about 10% below the level it would have been at if growth in GDP continued after 2008 at its long term rate of 3% per year.
At the height of the financial crisis, the media frequently had discussions of the "failure of capitalism", and the need to radically rein in the private sector through extensive regulations and other government activities. The politically liberal Congress elected in 2008 along with President Barack Obama reflected these views. In addition to taking various steps to try to fight the recession, leading members of the new Congress, and President Obama as well, considered they had a mandate to reengineer the American economy through more radical government interventions (see the discussion of uncertainty and the recovery by Steven Davis, Kevin Murphy, and myself in the Wall Street Journal, January 4, 2010, "Uncertainty and the Slow Recovery").
In addition to repeated attacks on American business, especially banks (some of the attacks on banks were well deserved), Congress passed an expensive stimulus package that did not stimulate much. The health care bill Congress passed seems likely to increase the cost to small and large businesses of providing health insurance for employees. Congressional leaders proposed high taxes on carbon emissions, large increases in taxes on higher income individuals, corporate profits, and capital gains as part of vocal attacks on "billionaires". Many in Congress wanted to cap, or at least control, compensation of executives. Proposals were advanced to make anti-trust laws less pro-consumer, and more protective of competitors from aggressive and innovative companies. Congress passed and the president signed a financial reform bill that is a complicated and a politically driven mixture of sensible reforms, and senseless changes that have little to do with stabilizing the financial architecture, or correcting what was defective in prior regulations.
It is no surprise that this rhetoric and the proposed and actual policies discouraged business investment and slowed down the recovery. Yet, I had expected the recovery to speed up after radical approaches to the American economy were repudiated in the 2010 Congressional elections, when many of the more liberal members of Congress lost their seats. For a while the economy did began to pick up, as unemployment declined quite rapidly from hovering around 10% to about 9% at end of 2010, and GDP started growing faster. But then the economy stalled. The challenge is to explain the drift in the unemployment rate during the past several months, and the rather tepid growth in GDP that have raised fears of a "double-dip".
Some of the slow-down in the American economy is undoubtedly due to problems in the world economy: the excessive Greece debt and other serious economic problems facing a slowly growing European Community, the nuclear disaster in Japan and the sluggishness of the Japanese economy, and the possible slowing of the rapid growth in both the Chinese and Indian economies. Another part is explained by the policies that slowed the early stages of the recovery, perhaps especially uncertainty about the effects of the financial reform act, and lack of clarity about the cost implications to business of the health care act.
I am persuaded that an important third part is due to concerns that the US will be unable to control its fiscal situation. The ratio of federal government spending to GDP grew from about 21% in 2007 to 25% in 2011, a very rapid change compared to the relative stability of this ratio during the prior 25 years. Unfortunately, there is not yet a strong enough will in Congress and by the president to lower this ratio during the coming decade. Indeed, with the looming enormous growth in entitlement spending, especially Medicare, the spending to GDP ratio could well increase sharply in the coming decade, along with the fiscal deficit and the federal debt.
Liberal Democrats continue to be reluctant to agree to big cuts in government spending. Many Republicans have come out against increasing any taxes, even though sensible tax reform toward a flatter and broader based income tax would raise the taxes paid by some taxpayers. The most attractive reform of Medicare put forward by any member of Congress is Paul Ryan's proposal to provide grants to the elderly to buy health insurance, with the size of the grant falling with the income of the recipient (see our discussion of his "Roadmap" in posts for April 4, 2011). But Ryan's Medicare proposal has been rejected not only by Democrats, but also by leading members of his own party.
To many investors, the future of the American economy looks dim and also uncertain. I am a perennial optimist about America, but even I have moments of serious doubts: not about the ability to solve these problems, but about the will to do so. The best way to get American fiscal and other economic problems under control, and thereby "stimulate" the economy, is to institute growth oriented policies that would increase the long-term growth rate beyond the 3% average annual GDP growth rate of the past 130 years. These policies include tax reform, cuts in entitlement spending, and more sensible regulations that are less dependent on discretion by regulators (see my post for December 6, 2010 for a discussion of these and other proposals).
Why the economic recovery is lagging—Posner
The U.S. economy is stagnant; the proposition that we had a mere "recession" which "ended" two years ago, is, like the terminology of sovereign default ("debt restructuring"), just an exercise in euphemism. Real (that is, inflation-adjusted) GDP per capita has declined by almost 3 percent since 2007. (This is on the assumption that the first-quarter 2011 increase in GDP at an annual rate of 1.8 percent, not adjusted for inflation or population growth, will be the full-year real per capita increase—in fact, if unadjusted GDP grows by less than 3 percent for the year as a whole, the real per capita GDP will decline.) At the same time, the national debt has soared (it is currently $14.3 trillion, of which $9.7 trillion is "public debt"—that is, debt owed bondholders rather than social security annuitants and other entitlement holders), and unemployment exceeds 9 percent, with about half the unemployed not having worked for at least six months.
The sharp and rapid decline of the economy that began with the financial crisis of September 2008 was expected to be followed by a sharp and rapid rise (making for a V-shaped economic cycle) when the crisis was resolved by the bank bailouts and other emergency measures taken by the Federal Reserve and the Treasury Department in the fall of 2008, and by the $878 billion stimulus enacted by Congress in February 2009. The economy did pick up in the fall of 2009, but progress since has been fitful.
Causal analysis is the Achilles heel of business-cycle economics. National economies are so complex, and so different from each other and over time (making cross-sectional and time-series analyses of business cycles inconclusive), that it is rare that a phase in the cycle can be explained satisfactorily, especially if an estimate of magnitude rather than just of direction is desired.
For what it's worth, I think the major impediment to economic growth at present is uncertainty on the part of the key economic actors, namely businessmen and consumers. Businessmen are hesitant to hire and invest and consumers to spend, in both cases because of uncertainty about their economic prospects.
I use "uncertainty" in the sense in which the economists Frank Knight and John Maynard Keynes distinguished between risk and uncertainty. Risk was a probability that could be estimated, uncertainty a risk that could not be estimated. The distinction is unpopular among economists because a nonquantifiable risk greatly complicates statistical analysis of economic phenomena, but it seems to me a real and important distinction when one is dealing with the business cycle. And there is a growing literature in economics on "ambiguity aversion," by which is meant aversion to uncertainty in the Knight-Keynes sense.
When a businessman has to decide whether to invest in a new product or a new plant or other facility, with the success of his decision dependent on future revenues and costs, there is bound to be an irreducible element—and possibly a very large element—of uncertainty; and likewise when a consumer has to decide on a major purchase, such as a house, or whether to seek a new job, or marry, or move to another part of the country, or retire, or seek more education. Any decision the success of which depends on future events is likely to involve uncertainty. And a common and usually sensible respond to uncertainty is simply to postpone the decision in the hope that the uncertainty will dissipate as new information becomes available. But the more postponement there is of investment, hiring, purchasing, and other economic decisions, the lower the level of economic activity. We observe this today with the enormous cash balances that large firms have accumulated and the drooping demand for houses.
The greater the uncertainty, the less forward-oriented economic activity there is likely to be, with adverse effects on investment, employment, and consumer spending. At present the U.S. economy is afflicted with at least five major sources of uncertainty. One is the economy of the eurozone. If Greece defaults on its public debt, which remains a possibility in the near future (a year or two years from now), this may have a domino effect. The dominos are not just the other weak eurozone countries—Ireland, Spain, Portugal, and Italy—but also the French and other European banks that are heavily invested in those countries and the American banks and (especially money-market funds) that are heavily invested in European banks.
Second is uncertainty about whether and on what terms Congress will raise the U.S. public-debt ceiling. Default is unlikely, but no one knows what deal the Republicans and Democrats will strike to avert default. Undoubtedly it will involve significant cuts in federal spending, and these cuts will hurt numerous businesses and individuals.
Third is uncertainty about federal regulation of the financial and health sectors. The ambitious health-care and financial-regulation reform statutes enacted by Congress in 2009 are very long and complicated, but at the same time incomplete—completion of these regulatory edifices was delegated to regulatory agencies that have not come close to finishing their work. No one can know how tightly banks and other financial institutions are going to be regulated or how the price of health care is going to be affected; and the cost and availability both of credit and of health care are of immense concern to businesses and individuals alike.
Fourth is a widespread suspicion in the business community that President Obama is in the pocket of the labor unions, is viscerally hostile to business, and is entirely focused on winning reelection. The suspicion is (in my opinion) greatly exaggerated, but is real.
Fifth, there is a sense that politicians the world over, notably including the United States, are preoccupied with the very near term and are simply postponing the day of reckoning with the world's economic problems that grew out of the financial crisis of September 2008 and the ensuing global economic crisis, which is still with us. The Greek example is a good one. Because Greece is stuck with the euro, it cannot climb out of its economic hole by devaluing its currency, a tried and true recipe for dealing with a severe economic downturn, because it increases exports and reduces imports, and both effects stimulate domestic employment. Greece as a result is broke, and if it had defaulted last year the eurozone might by now be in tolerable economic shape. Instead Greece seems about to receive a fiscal bandaid that will keep it going for a year or two, which means that any U.S. firm that has a stake in the eurozone and a planning horizon of at least a couple of years must cope with the uncertainty of Greece's economic future.
A parallel example is the efforts of our government to revive the housing market by providing relief to mortgagors; the efforts appear to have prolonged the depression of the housing market, which had it been allowed to hit bottom might be on the mend today. Similarly, the federal fiscal imbalance and mounting deficit are unlikely to receive more than bandaid treatment until the November 2012 elections; businesses and consumers will be tempted to hold their breath until then. Suppose that finally after those elections the government gets serious and closes the fiscal gap through some combination of higher taxes, reduced government spending, and programs designed sensibly or otherwise to stimulate economic growth. Because the gap is so large, and will probably be larger 16 months from now, and because the combination that will close it is likely to have profound and uneven economic consequences, many businesses and consumers alike will want to put many of their own economic plans on hold until they have a clearer idea of the terms of the gap-closing combination, which they may not have for years.
I don't want to give an exaggerated picture of the consequences of Knight-Keynes uncertainty. It does not paralyze economic activity, but it slows it down and may be a large factor in the current sluggishness of the U.S. economy.