July 9, 2010
Where the Economy Is and Where it’s (Apparently) Going

There are two sorts of downturn: cyclical downturns, where businesses expand perhaps a bit much, are stuck with excess capacity, and then have to lay off workers. It’s not pleasant. Growth slows. Unemployment rises. Living standards fall. But the economy doesn’t depart very far from its long-term upward trajectory. Recovery arises when the central bank sets short-term interest rates sufficiently low that investment is again profitable. Employment and incomes then rise and growth resumes.

A downturn caused by a financial crisis or asset market collapse is different. Wealth is wiped out on a massive scale. As wealth-holders try to recoup their liquidity positions and honor obligations by deleveraging, asset prices fall further, vaporizing still more wealth, and so on. It’s a downward vicious cycle, like falling off a cliff. Merely lowering short-term interest rates won’t stimulate much investment since consumer demand is low and in any case credit will be scarce if many businesses and households are of questionable solvency. The economy can be awash in liquidity, as in fact it is, thanks to the Fed, and this no doubt helps on the margin. But if profitable investment opportunities are scarce because of low consumer demand, economic activity will remain minimal. Recovery awaits restoration of previous wealth levels, inherently a very slow process.

How bad is the downturn? All early indicators suggested a crisis every bit as bad as, if not worse than, the Great Depression. Charts provided by Barry Eichengreen and Kevin H. O’Rourke make this plain:

World Trade

The key difference between now and the 1930s is that in the current episode a recovery began around 12 to 14 months in (around April to June of 2009). Why? Because of government action: massive stimulus in many countries, bailouts of financial institutions, and unprecedentedly expansionary monetary policy. We’ve learned at least something from the past.

Kenneth Rogoff and Carmen Reinhart, in their exhaustive historical survey of financial crises, find that in the aftermath of such crises unemployment on average rises a full seven percent over an almost five-year period, that output falls on average nine percent over a two-year period, and that government debt rises on average 86 percent, in the post-World War II period, largely because of a collapsing tax base and government stimulus efforts. By those standards, our recovery is ahead of schedule, with unemployment rising just 5.6 percent over a little less than two years (from 4.8 percent in April 2008 to its probable peak of 10.4 percent in February 2010), and output growing since last summer after contracting for one year.

The reason for our relatively rapid recovery is, of course, government action, notably the stimulus. All three major macroeconomics forecasting firms, IHS Global Insight, Macroeconomic Advisers, and Moody’s Economy.com agree that the stimulus played a major role. (See this, this and this.) The CBO’s projections of jobs created by the stimulus are as follows (but note the tapering off toward the end of 2010 as the stimulus fades away):

Historical studies (see, for example, this) demonstrate that stimulus is, well, stimulative. Theoretical studies (e.g., this and this) show plausible mechanisms whereby stimulus is especially expansionary when, as now, the federal funds rate is zero.

Common estimates of the multipliers of various kinds of spending and tax cuts are as follows (these provided by Moody’s Economy.com):

Each term represent the one-year dollar change in GDP for a given dollar reduction in federal tax revenue or increase in spending. Note the estimated multiplier for extension of unemployment benefits, 1.61, which means that for each dollar of unemployment benefits, GDP is expected to rise by $1.61 over the following year. (And for clarity, a multiplier larger than 1 means there’s no net crowding-out effect within one year of the injection, though there may be in future years as the stimulative effects taper off.) Plausibly this is the best stimulus there is, in part because the multiplier is big, but also because it’s easy to implement and the money gets into the economy fast.

Republicans in the Senate, however, are blocking renewal of unemployment benefits on the grounds that it will worsen our long-term fiscal problems. So we have the spectacle of the very people who, when they entered the White House in 2001, were bequeathed surpluses as far as the eye can see and quickly, through tax cuts, wars, and (of all things) an unfunded Medicare entitlement, turned them into deficits as far the eye can see, now claiming that any additional stimulus—which in contrast to their tax cuts has a minimal impact on deficits and in the long run would improve federal finances since nothing enhances revenues as effectively as growth—is unaffordable. It’s enough to make one scream.Yet it’s just part of a broader, inexplicable, global policy decision to nip successful stimulus in the bud before its objective has been achieved. As David Leonhardt writes in his June 29^th column: “The world’s rich countries are now conducting a dangerous experiment. They are repeating an economic policy out of the 1930s—starting to cut spending and raise taxes before a recovery is assured—and hoping today’s situation is different enough to assure a different outcome.” (The pattern is familiar from history. Why, during severe downturns caused by financial crises policymakers, like FDR in the 1930s, Japan in the 1990s and 2000s (see Posen), and European leaders today, seem ineluctably drawn toward withdrawal of stimulus before recovery is complete is a topic for political science research.)

Republicans’ claim that unemployment benefits encourage unemployment is to some extent true, but it’s a small effect (see Krugman). And obviously when macroeconomic forces have thrown millions of people out of work, so that for every job vacancy there are five applicants rather than the usual one, tinkering with incentives will have little effect on the overall unemployment problem. On the other hand, stimulating the economy, through such measures as extending unemployment benefits, will.

But Republicans aren’t actually serious about the long-term fiscal problems. The latter are summarized in this chart provided by the Center for Budget and Policy Priorities, based on CBO data:

Our long-term fiscal problems largely concern health care costs. Yet the first serious effort to start to get control of health care costs (the Patient Protection and Affordable Care Act) was demagogued by Republicans as “cutting Medicare” (this from the party that opposed Medicare when it was proposed and tried to cut it sharply in the 1990s).