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U.S. Monetary Policy and the Financial Crisis James R. Lothian1 Fordham University Abstract: This paper reviews U.S. Federal Reserve policy prior to and during the course of the recession that began in December 2007. It compares those policies to monetary policy during the Great Depression of the 1930s with which this recession has been likened. It then goes on to discuss what policymakers will need to do to in the future to avoid a surge in inflation and the difficulties which they are apt to face in implementing the necessary shift in policy. JEL Classifications: E32, E51, E52, N12 Keywords: Macroeconomics, Money, Monetary policy, Business cycles, Great Depression 1. Introduction Richard Posner (2009) has written a new book entitled A Failure of Capitalism: The Crisis of '08 and the Descent into Depression. In viewing the 1930s debacle and the current recession as similar, Posner is certainly not the odd man out. 2 As other commentators have pointed out, both episodes are characterized by crises in the financial system. Both have been preceded by substantial run-ups in asset prices. Both have been worldwide in scope. There are, however, fundamental differences between the two. One difference should be obvious but often is ignored – the very much milder declines in real income and increases in unemployment in the current episode than during the 1930s.3 A second which is less obvious but directly related to the first is monetary policy. Here I focus in particular on money-supply behaviour. Doing so is somewhat counter to the current emphasis on real interest rates and Taylor-type rules as a gauges of monetary policy, but imposing that framework on analysis of policy in 1 James R. Lothian is Distinguished Professor of Finance at Fordham University, 113 West 60th Street, New York, NY 10023, USA, tel. 1 212 636-6147; fax 1 212 765-5573; emails jrmlothian@aol.com lothian@fordham.edu . I would like to thank John Devereux, Cornelia H. McCarthy and Gerald P. Dwyer, Jr. for their comments. 2 See, for example, Barry Eichengreen and Kevin H. O’Rourke (2009). 3 Real GNP from the cycle peak in 2007 fourth quarter to 2009 first quarter has declined 2.4 percent. During the comparable period in the Great Depression it declined 12.9 percent. The U.S. unemployment rate in May 2009 was 9.4 percent. In 1931, it was 15.9 percent and two years later reached close to 25 percent. 25 Journal of Economic Asymmetries, Vol. 6 No. 2, September 2009, ISSN 1703-4949 26 The Journal of Economic Asymmetries December 2009 the Depression era would not only be anachronistic but would lead to nonsensical inferences.4 Unlike the Great Depression in which the money supply in the United States plummeted in the wake of widespread bank failures, money supply in this episode has continued to increase and in the course of this year has accelerated. The next section of this paper documents this difference. It then discusses the role of policy in the years preceding the current crisis. Here the data are more ambiguous, but point to an overly excessively expansive policy on the part of the Federal Reserve as a factor fueling the increase in housing prices prior to the onset of the current U.S. recession. The paper concludes with a discussion of the dangers posed by the Federal Reserve's policy stance during the course of the period since late 2008, the “exit strategy” that the Fed will need to pursue and the possible impediments to its implementation. 2. Money in the Great Depression and the Current Recession Figure 1 plots the logarithms of money supply for periods preceding and following the respective NBER-defined business cycle peaks of August 1929 and December 2007. The point of reference in choosing the periods over which to plot the data is the Great Depression, the 21 months from the previous cycle trough in November 1927 until August 1929 and the 43 months from then until the trough in March 1933. The M2 series for the Depression is that of Milton Friedman and Anna J. Schwartz (1970) and for the current recession that of the Federal Reserve. Figure 2 provides a similar chart of the data for measures of the monetary base. The sources of these data are Friedman and Schwartz (1963a) and the Federal Reserve Board. Figure 3 plots the ratio of M2 to the monetary base, the money multiplier, for the two periods. The contrast between the behaviour of both M2 and the monetary base in these two episodes is readily apparent from a glance at the charts. In the Depression, M2 fell progressively, driven downward by three waves of banking panics and the decreases in the public’s preferences for deposits relative to currency and of banks’ preferences for deposits relative to reserves that the panics engendered. Friedman and Schwartz argued convincingly that this succession of monetary shocks and the Federal Reserve’s failure to offset them is what made the 1930s depression “great.” 4 See the critique by Gandolfi and Lothian (1977) of one attempt to apply this framework to the Great Depression. Vol. 6 No. 3 Lothian: U.S. Monetary Policy and the Financial Crisis 27 Figure 1: M2 in Two Cycles Ben Bernanke, the current Fed chairman, has expressed full agreement with Friedman and Schwartz’s conclusions. In a paper (2002) that he delivered at a conference honoring Milton Friedman on his ninetieth birthday, Bernanke stated: “Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: ‘Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.’ ” Bernanke in this regard has been a man of his word. Whether he should have demonstrated that by taking the particular actions that he has in this episode is another question. Schwartz in a recent interview argues that he should not have, that Bernanke has, in fact, greatly misjudged the nature of the crisis. “The Fed,” Schwartz said, “has gone about as if the problem is a shortage of liquidity. That is not the basic problem. The basic problem for the markets is that [uncertainty] that the balance sheets of financial firms are credible.” (Carney, 2008).5 5 In this regard see Bordo (2009). 28 The Journal of Economic Asymmetries December 2009 Figure 2: The Monetary Base in Two Cycles In any event, monetary policy, far from being contractionary, has been expansive since December 2007 when the U.S. economy peaked and entered recession. The money supply has increased by 11 percent, and with the base having more than doubled since fall 2008, it is highly doubtful that M2’s course will reverse. In the Great Depression, over the comparable period from August 1929 to February 1931, M2 already had decreased by 5 percent, and that was before the onset of the second wave of banking failures in October 1931. By the time the trough finally was reached in March 1933, M2 had fallen by 33 percent. The point is that there simply has been no monetary shock during the course of this recession. That is very important. Historically, such shocks have been the major factor producing severe contractions in the United States, as both Friedman and Schwartz (1963a, 1963b) and Phillip Cagan (1965) have documented. Similar evidence of the key role played by money supply in major cyclical fluctuations exists for Britain and of a monetary transmission mechanism linking cyclical fluctuations in that country with those in the United States (Huffman and Lothian, 1983). In this regard, the Great Depression stands out in degree, but not in kind. Evidence for milder cyclical declines in both countries is more mixed, with both real and monetary factors appearing to play a role. Vol. 6 No. 3 Lothian: U.S. Monetary Policy and the Financial Crisis 29 Figure 3: The Money Multiplier in Two Cycles Now let us turn attention to two related developments that require comment. The first is a comparison of movements in the money multiplier in the two episodes. As Figure 3 shows, by April 2009, the latest month for which data are available, the money multiplier already had fallen by as much as it did during the entire Great Depression. The second is brought out in Figure 4 which plots quarterly data for the income velocity of M2 in the two episodes. The paths followed by velocity up until the same point in the respective cyclical appear very nearly identical.6 6 The quarterly data for nominal GNP in the two episodes are taken from Balke and Gordon (1990) and the website of the Bureau of Economic Analysis of the U.S. Department of Commerce, respectively. 30 The Journal of Economic Asymmetries December 2009 Figure 4: Velocity in Two Cycles This steep decline in the money multiplier in recent months and its similarity to the decline in the money multiplier during the course of the Great Depression, at first glance, are unsettling. There is, however, less here than meets the eye. The two declines, though similar in magnitude, are manifestations of two very different types of underlying behaviour. In the Depression, the decline came after the fact, as response to the banking failures. Individuals and businesses altered the mix between their holdings of deposits and currency because of their distrust of banks. Banks, faced with deposit drains, called in loans attempting to build up reserves. In the current episode, in contrast, the decline appears to be the first-round result of the massive injections of base money by the Fed. Bank deposits, and loans have continued to grow, just not at anything close to the same extremely rapid pace as the base.7 The genesis of the current decline in velocity could be due to either of two things, or perhaps some combination of the two. On the one hand, it could be a short-run transient phenomenon, produced in the first instance by the acceleration in M2 growth and the inevitable lag before that monetary acceleration finds its way into increased spending. That would be consistent with buffer-stock models of money 7 See Gavin (2009) for an analysis of the Federal Reserve’s balance sheet during the current episode. He shows, among other things, that the bulk of the increase in the base has gone into holdings of excess reserve by banks. Also see Thornton (2009). Vol. 6 No. 3 Lothian: U.S. Monetary Policy and the Financial Crisis 31 demand (e.g., Carr and Darby, 1981) and other similar short-run monetary models (Gandolfi and Lothian, 1983; Lothian, Darby and Tindall, 1990). Alternatively it may reflect an increase in desired real money balances on the part of the public, the result either of declines in the opportunity cost of holding money as interest rate have fallen, or of increased uncertainty with regard to the economic outlook. An increase resulting from uncertainty is somewhat more troubling, but not at all surprising, given the unprecedented problems in the credit markets and the haphazard government policy responses to them. The severe decline in velocity during the course of the Great Depression and associated increase in the public’s holdings of real money balances have been widely described as the result of a liquidity trap. The basic notion here is that in situations in which short-term interest rates are near zero, the demand for money balances becomes metastable. Increases in the nominal stock of money, regardless of their size, are willingly held and hence have no effect on spending, either nominal or real. Monetary policy becomes impotent. If it was the case the 1930s, could the United States be in the early stages of such an episode now, as Paul Krugman (2008) argues?8 There are two very good reasons to believe not. The first is empirical. The demand for money function did not in fact change in such a way during the Great Depression or in the years thereafter in which short-term interest rates continued to be low, contra the myths and legends surrounding the Depression era. It remained stable: The evidence both from studies using time-series data (Meltzer, 1963; Gandolfi and Lothian, 1977) and from studies using cross-state panel data (Gandolfi, 1974; Gandolfi and Lothian, 1976) is quite clear in this regard. The second reason is theoretical. Underlying the notion of the liquidity trap is a narrow view of the transmission mechanism for monetary policy in which short-term credit instruments are the only substitute for money. That, however, is completely unrealistic – the range of substitutes is much broader, including other types of securities, real assets, non-durable goods and services. Incipient excess supplies of money will result in a portfolio adjustment process involving increases in nominal spending on this entire range of substitutes.9 8 Krugman writes: “Here’s one way to think about the liquidity trap — a situation in which conventional monetary policy loses all traction. When short-term interest rates are close to zero, open-market operations in which the central bank prints money and buys government debt don’t do anything, because you’re just swapping one more or less zero-interest rate asset for another. Alternatively, you can say that there’s no incentive to lend out any increase, in the monetary base, because the interest rate you get isn’t enough to make it worth bothering. … As of 10:38 this morning [March 17, 2008], the one-month Treasury rate was 0.57; the threemonth rate was 0.825. Are we there yet? Pretty close.” Note that Krugman confuses two things here – effects on the demand for money and effects on the supply of money. The concept of the liquidity trap only applies to the demand for money. 9 See Brunner and Meltzer (1963) and Friedman and Schwartz (1963b) and, for a more recent discussion and interesting empirical evidence, Meltzer (2001). 32 The Journal of Economic Asymmetries December 2009 3. Monetary Policy Prior to the Cycle Peak The question now to be addressed is the stance of policy in the years leading up to the current crisis. Was it overly expansive and thus a precipitating factor in the crisis? A number of commentators, arguing from rather different perspectives, have claimed that it was. Some pointed to incipient problems before the event, though writing when they did, could not have foreseen the details of what ultimately transpired (Shadow Open Market Committee, Statements of April 15, 2002 and November 10, 2003). Others, like John B. Taylor (2007, 2009) who have written while the crisis has been underway and hence have had the advantage of a bit of hindsight are more specific in their analyses. The story that has now emerged is the following.10 At the heart of the financial crisis – the sine qua non, if you will – were the subprime mortgages that banks in the United States made at the urging of the U.S. Congress and that the banks subsequently securitized. Much of this securitization took the form of collateralized debt obligations (CDOs). Unlike the conventional residential mortgage-backed bonds (RMBs) that banks had been issuing for several decades, there was nothing “plain vanilla” about CDOs. CDOs are hybrid instruments – heterogeneous and rather opaque combinations of RMBs of varying quality. They are traded over the counter and they are much more difficult to value than RMBs. When housing prices peaked and then began to fall, sometime between mid2006 and early 2007 depending upon the particular index, defaults on subprime mortgages began to increase dramatically. This, in turn, had adverse effects on the market for CDOs. Counterparty risk increased. Via a variety of channels, and as a result of some of the policies subsequently pursued, the problems in the CDO market spilled over to the rest of the U.S. credit market and to credit markets abroad. (See Dwyer and Tkac, 2009). What role did monetary policy play in the crisis? Figure 5 presents data on the monthly rate of growth of M2 measured on a year-over-year basis and the estimated monthly level of the real federal funds rate, alternative measures of the Fed’s policy stance. The latter is defined as the nominal effective federal funds rate minus the continuously compounded year-over-year rate of growth of the personal consumption expenditure deflator. Table 1 presents averages of these data for various subperiods. 10 In addition to Taylor (2009), see the detailed discussions of various aspects of the current episode by Gerald P. Dwyer, Jr. and Paula Tkac (2009) and Michael T. Melvin and Mark P. Taylor (2009) in papers presented at the conference on “The Global Financial Crisis: Causes, Threats and Opportunities,” held at the Warwick Business School and co-sponsored the Journal of International Money and Finance. Vol. 6 No. 3 Lothian: U.S. Monetary Policy and the Financial Crisis 33 Table 1: Period Averages of the Real Federal Funds Rate and Year-over-year Growth in M2 Period 2000 2001-2003 2004-2005 2006-2007 2008-2009 Real funds rate M2 growth 3.78 -0.14 -0.47 2.34 -1.21 5.86 6.99 4.76 5.38 8.13 The stories told in the chart and the table by the two policy indicators are largely, though not completely, the same. For most of the period, the two provide similar readings of Fed policy. Viewed on the basis either of M2 growth or the level of the real federal funds, monetary policy was clearly quite expansive in 2001-2003, Figure 5: The Real Federal Funds Rate and M2 Growth was more restrictive in both 2000 and in 2006-2007, and turned more expansive again in 2008 and 2009. The one period in which the two measures differed as gauges of policy was 2004-2005. The real funds rate on average was negative, 34 The Journal of Economic Asymmetries December 2009 suggesting substantial monetary ease, while M2 growth was relatively restrained 4.8 percent per annum on average. Maintained over the longer run, such a rate of M2 growth normally would be consistent with roughly the same rate of growth of nominal income and, given a long-run rate of real income growth of three percent per annum or more, a two percent or lower rate of inflation. The -.5 percent average level of the real federal funds rate, in contrast, implies a much higher average rate of inflation. That, in any event, is the story told by the Taylor-Rule equations. We can see this clearly in Figure 6, which is taken from the June 2009 issue of Monetary Trends published by the Federal Reserve Bank of St. Louis. Shown in that chart are plots of the actual nominal federal funds rate and the implied federal funds rates for target inflation rates, ranging from 0 to 4 percent per annum over the period 2000 to the present. The calculations in the chart are based on the following equation: R*t = 2.5 + πt –1 + .5 (πt –1–π*) + .5 [100 x (y t–1 – y* t –1)], (1) where R*t is the implied federal funds rate; πt –1 is the year-over-year inflation rate in the previous period as measured by the personal consumption expenditures price index; π* is the target inflation rate; y t–1 is the log of the real gross domestic product in the rate in the previous period; and y* t –1 is the log of an estimated level of potential output in the previous period. Figure 6: Source: Monetary Trends, Federal Reserve Bank of St. Louis, June 2009. Using that equation, the data in Table 1 and assuming that actual and potential output are equal, which was approximately the case in 2004-2005, we can derive a point estimate of the average rate of inflation in that period. This works out to be just under 6 percent per annum. The actual inflation rate, however, averaged 2.8 percent per annum, roughly three percentage points lower than the Taylor Rule would imply and a percentage point or more higher than M2 growth would imply. Neither policy measure, therefore, accurately depicts the average behaviour of prices during this two-year Vol. 6 No. 3 Lothian: U.S. Monetary Policy and the Financial Crisis 35 period. Inflation did rise, as a focus on real interest rates as a policy measure would suggest, but not soon enough and for a long enough period to substantially affect the average. Nevertheless, there is some evidence that housing was affected by the Fed’s maintenance of a low funds rate. Taylor (2009) finds an inverse relationship between house prices and interest rates.11 His counterfactual simulation suggests further that the run-up in house prices would have been much more muted had the Fed raised its funds-rate target much earlier than it did. Finally, let us address the question of Fed policy in the period immediately preceding the crisis. Here the chart and table tell the same story – policy was a good deal tighter when viewed on either basis than in the two or so years before that. It thus appears to have been a catalyst for the declines in house prices and home sales that did ultimately materialize. 4. Monetary Policy: The Task Ahead In the short period from August 2008 until April 2009, the Federal Reserve’s own monetary liabilities, the monetary base, have more than doubled. To date, these increases have not spilled over in a major way to money-supply growth, and the increases in M2 growth that we have seen have been offset by declines in velocity. All of this is clear from the charts presented earlier. Nominal aggregate demand, therefore, does not appear to have been affected. Even if it had been, moreover, it is quite arguably the case that in current conditions of unemployment, there would be little, if any, immediate effect on inflation. That of course is the logic underlying the Phillips curve. The unadorned Phillips curve, however, is a short-run relationship. In the long run, inflation is a monetary phenomenon. The evidence in this regard is both ubiquitous and incontrovertible. Something, therefore, will have to give: At some point, the Fed either will have to engage in a massive drain of reserves or be willing to suffer the inflationary consequences.12 In a narrow mechanical sense, the mission to drain reserves and thus put monetary policy on a less potentially inflationary track is doable, for the most part simply a bigger version of the reserve drains that the Fed effected after the muchballyhooed Y2K crisis that never materialized and after the 9-11 terrorist attacks. When the Fed does try to drain reserves, however, it will face several problems that it did not encounter in those two earlier episodes. The first is one of timing, of picking the right point in time to shift its stance. It will have to do so before the event. That will not be at all easy in the current, still quite uncertain, environment. Fed officials not only will have to accurately gauge how rapidly the economy is approaching full employment; they also will also have to gauge inflation expectations and how they are changing. They will also be selling different assets 11 Arend, et al. (2008) present somewhat similar evidence for EU and other OECD countries. One possible mitigating factor here is the move by the Federal Reserve in October 2008 to pay interest on reserves. This doubtless led to increases in desired holdings of reserves by banks. 12 36 The Journal of Economic Asymmetries December 2009 than usual, since the Fed’s balance sheet now includes a host of different securities, many of longer maturity and lower quality than the U.S. treasury bills that have been the standard “stuff” of open-market operations. Finally, because the Federal Reserves now is paying interest on banks’ deposits at the Fed, desired excess reserves will have changed. The Fed will, therefore, need to estimate the magnitude of this effect. Though not necessarily inconsequential, these problems are purely technical. The potentially more serious problems are political. When the Fed sells securities to remove reserves from the system, their prices will fall and interest rates across the maturity spectrum will rise. That is always a difficult sell politically. In the current environment in the United States, it will be even more so. Put simply, there is precious little evidence that inflation is of any concern at the moment to either the majority of Congress or the current administration. The rhetoric from Washington and the actions that the government has taken have been totally focused on the recession. Fed officials, therefore, are likely come under substantial political pressure to reverse their tightening course. Adding to the problem are the sizable government budget deficits being projected for the years ahead, which will themselves be a source of incipient upward pressure on rates across the maturity spectrum. Estimates by the Congressional Budget Office show deficits of 8.3, 4.9, and 3.3 percent of nominal GDP in the years 2009 to 2011, respectively. Their estimates of debt held by the public as a ratio to nominal GDP are 50.5, 54.2, and 54.4 for the same years, figures not seen since the aftermath of World War II. Fed officials are aware of the potential problems, as a recent statement by Richard Fisher, President of The Federal Reserve Bank of Dallas attests (O’Grady, 2009). And in what is almost a parody of game theory, members of Congress seem aware of the attitude of Fed officials. Some members of Congress have, in fact, already begun to make noises about reigning in the power of the regional bank presidents over policy. In the environment of the late 1970s and early 1980, when the Bank of England under Sir Gordon Richardson and the Federal Reserve under Paul Volcker took action to break the inflationary cycles of the preceding decade and a half, the two central bankers had the strong political backing of Prime Minister Margaret Thatcher and President Ronald Reagan, respectively. That is not the case now. Allan H. Meltzer has recently (2009) voiced a similar opinion: Paul Volcker is now the head of President Obama’s Economic Recovery Advisory Board. Mr. Volcker and the administration’s many economic advisers are all fully aware of the inflationary dangers ahead. So is the current Fed chairman, Ben Bernanke. … I do not doubt their knowledge or technical ability. What I doubt is the commitment of the administration and the autonomy of the Federal Reserve. Mr. Volcker was a very independent chairman. But under Mr. Bernanke, the Fed has sacrificed its independence Vol. 6 No. 3 Lothian: U.S. Monetary Policy and the Financial Crisis 37 and become the monetary arm of the Treasury: bailing out A.I.G., taking on illiquid securities from Bear Stearns and promising to provide as much as $700 billion of reserves to buy mortgages. Other commentators, however, disagree. Krugman, for example, argues that deflation, rather than inflation, is the problem that has to be avoided. In a column in the New York Times entitled “Falling Wage Syndrome,” he states: Credit where credit is due: President Obama and his economic advisers seem to have steered the economy away from the abyss. But the risk that America will turn into Japan — that we’ll face years of deflation and stagnation — seems, if anything, to be rising. In this connection, it seems useful to make one more comparison with the Great-Depression period, this time of price behaviour. To this end the quarterly GNP deflator for the current episode and the Depression on a similar scale to that used earlier have been plotted. The two series are shown in Figure 7. The contrast between the two episodes is readily apparent – a continued large decline throughout the Depression period – 27 percent from peak to trough – and an upward trend in this one. If deflation is in the offing, it certainly is not apparent in these data. Figure 7: GNP Deflators in Two Cycles 38 The Journal of Economic Asymmetries December 2009 4. Concluding Remarks The focus of this paper has been on Federal Reserve policy prior to and during the course of the recession that began in the United States in December 2007. It has compared those policies to monetary policy during the Great Depression of the 1930s with which this recession has been likened. The conclusion here is that policy in these two episodes has differed greatly. In the Depression, money was the principal player, the series of monetary shocks resulting from the recurrent banking crises turning an otherwise severe recession into a debacle of unprecedented proportions. In the current recession money has played a bit role. The issue going forward is what the Federal Reserve will do for an encore. Its own monetary liabilities, the monetary base, have more than doubled. Much – but not all – of that increase has gone into banks’ excess reserves. At some point, as the uncertainty surrounding both policy and the condition of the economy dissipates, that will change, and bank lending and bank deposits will begin to increase more rapidly. To avoid a surge in inflation, the Fed will then have to reverse course and drain reserves from the banking system. It will face two problems in doing so, the first technical in nature and the second political. How adept it will be in overcoming the technical problems, and perhaps more important, whether it can withstand the political pressures, are the key questions and themselves a source of continued uncertainty. 5. References Ahrend, R., Cournède, Boris and Price, Robert , (2008), “Monetary Policy, Market Excesses and Financial Turmoil,” OECD Economics Department Working Paper No. 597. Balke, Nathan and Gordon, Robert J., (1990), “Appendix B Historical Data,” in Robert J. Gordon , (ed.), The American Business Cycle: Continuity and Change. Chicago: University of Chicago Press for the NBER. Bernanke, Ben S., (2002), “Remarks at the Conference to Honor Milton Friedman, University of Chicago.” Board of Governors of the Federal Reserve System. http://www.federalreserve.gov/boarddocs/speeches/2002/20021108/default. htm Board of Governors of the Federal Reserve System, on-line data base. http://www.federalreserve.gov/econresdata/releases/statisticsdata.htm Bordo, Michael D., (2009), “The Great Contraction and the Current Crisis: Historical Parallels and Policy Lessons,” paper presented at the Shadow Open Market Committee Symposium on April 24. Brunner, Karl and Meltzer, Allan H., (1963), "The Place of Financial Intermediaries in the Transmission of Monetary Policy," American Economic Review, May, 53(2), 372-382. Cagan, Phillip, (1965), Determinants and Effects of Changes in the Stock of Money, 1875-1960. Princeton: Princeton: Princeton University Press for the NBER. Vol. 6 No. 3 Lothian: U.S. Monetary Policy and the Financial Crisis 39 Carney, Brian M., (2008), “The Weekend Interview: Anna Schwartz. Bernanke Is Fighting the Last War.” Wall Street Journal, October 18. Carr, Jack and Darby, Michael R., (1981), “The Role of Money Supply Shocks in the Short-Run Demand for Money,” Journal of Monetary Economics, September, 8(2), 183 -199. Dwyer, Gerald P., Jr. and Tkac, Paula, (2009), “The Financial Crisis of 2008: Fixed Income Markets,” paper presented at the JIMF-Warwick Business School conference on The Global Financial Crisis: Causes, Threats and Opportunities, Warwick University, April 6, 2009. Eichengreen, Barry and O’Rourke, Kevin H., (2009), “A Tale of Two Depressions, “ VOX.org, June 4 http://www.voxeu.org/index.php?q=node/3421 Federal Reserve Bank of St. Louis, Monetary Trends, June 2009. Friedman, Milton and Schwartz, Anna J., (1963), A Monetary History of the United States, 1867-1960. Princeton: Princeton University Press for the NBER. (1963a. Friedman, Milton and Schwartz, Anna J., (1963), “Money and Business Cycles.” Review of Economic Statistics, 45(1, Part 2, Supplement), 32-64. (1963b) Friedman, Milton and Schwartz, Anna J., (1970), Monetary Statistics of the United States: Estimates, Sources, Methods. New York: Columbia University Press for the NBER. Gandolfi, Arthur E., (1974), "Stability of the Demand for Money during the Great Contraction," Journal of Political Economy, September-October, 82(5), 969-83. Gandolfi, A.E., and Lothian, James R., (1976), “The Demand for Money from the Great Depression to the Present,” American Economic Review May, 66(2), 46-51. Gandolfi, Arthur E. and Lothian, James R., (1977), “Did Monetary Forces Cause the Great Depression: A Review Essay” Journal of Money, Credit and Banking, November, 9(4), 679-691. Gandolfi, Arthur E. and Lothian, James R., (1983),” International Price Behavior and the Demand for Money,” Economic Inquiry, July, 21(3), 295-311. Gavin, William T., (2009), “More Money: Understanding Recent Changes in the Monetary Base,” Federal Reserve Bank of St. Louis Review, March/April, 91(2), 49-59. Huffman, Wallace E. and Lothian, James R., (1984), "The Gold Standard and the Transmission of Business Cycles, 1833 to 1932," in Michael Bordo and Anna J. Schwartz, (eds.), A Retrospective on the Classical Gold Standard. Chicago: University of Chicago Press for the NBER. Krugman, Paul, (2008), “How close are we to a liquidity trap?” krugman.blogsnytimes.com, March 17. http://krugman.blogs.nytimes.com/2008/03/17/how-close-are-we-to-aliquidity-trap/ 40 The Journal of Economic Asymmetries December 2009 Krugman, Paul, (2009), “Falling Wage Syndrome,” New York Times, May 3. http://www.nytimes.com/2009/05/04/opinion/04krugman.html?_r=1 Lothian, James R., Darby, Michael R. and Tindalll, Michael, (1990), "Buffer Stock Models of the Demand for Money and the Conduct of Monetary Policy," Journal of Policy Modeling, Summer, 12(2), 325-345. Meltzer, Alan H, (1963),“The Demand for Money: Evidence from the Time Series,” Journal of Political Economy, June, 71(3), 219-46. Melvin, Michael T. and Taylor, Mark P., (2009), “The Crisis in the FX Market,” paper presented at the JIMF-Warwick Business School conference on The Global Financial Crisis: Causes, Threats and Opportunities, Warwick University, April 6, 2009. Meltzer, Allan H, (2001), “The Transmission Process,” in Deutsche Bundesbank, (ed.). The Monetary Transmission Process: Recent Developments and Lessons for Europe, Basingstroke: Palgrave Publishers. O'Grady, Mary Anastasia, (2009), “Don't Monetize the Debt. The president of the Dallas Fed on inflation risk and central bank independence,” Wall Street Journal, May 23, p. A9. Posner, Richard A, (2009), A Failure of Capitalism: The Crisis of '08 and the Descent into Depression, Cambridge, MA: Harvard University Press. Shadow Open Market Committee, “Policy Statement,” April 15, 2002. http://www.somc.rochester.edu/Apr02/Statement04-02.pdf Shadow Open Market Committee, “Policy Statement,” November 10, 2003. http://www.somc.rochester.edu/Nov03/SOMCstatement1103.pdf Taylor, John P., (2007), “Housing and Monetary Policy” a paper delivered at the Jackson Hole Conference of the Federal Reserve Bank of Kansas City, September 2007. Taylor, John B, (2009, Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis, Stanford: Hoover Press. Thornton, Daniel L., (2009), The Fed, Liquidity, and Credit Allocation, Federal Reserve Bank of St. Louis Review, January/February, 91(1), 14-21. U.S. Department of Commerce, Bureau of Economic Analysis, http://www.bea.gov/ Economic Recovery: Sustaining U.S. Economic Growth in a Post-Crisis Economy Craig K. Elwell Specialist in Macroeconomic Policy April 18, 2013 Congressional Research Service 7-5700 www.crs.gov R41332 CRS Report for Congress Prepared for Members and Committees of Congress Economic Recovery: Sustaining U.S. Economic Growth in a Post-Crisis Economy Summary The 2007-2009 recession was long and deep, and according to several indicators was the most severe economic contraction since the 1930s (but still much less severe than the Great Depression). The slowdown of economic activity was moderate through the first half of 2008, but at that point the weakening economy was overtaken by a major financial crisis that would exacerbate the economic weakness and accelerate the decline. Economic recovery began in mid-2009. Real gross domestic product (GDP) has been on a positive track since then, although the pace has been uneven and slowed significantly in 2011. The stock market has recovered from its lows, and employment has increased moderately. On the other hand, significant economic weakness remains evident, particularly in the balance sheet of households, the labor market, and the housing sector. Congress was an active participant in the policy responses to this crisis and has an ongoing interest in macroeconomic conditions. Current macroeconomic concerns include whether the economy is in a sustained recovery, rapidly reducing unemployment, speeding a return to normal output and employment growth, and addressing government’s long-term debt problem. In the typical post-war business cycle, lower than normal growth during the recession is quickly followed by a recovery period with above normal growth. This above normal growth serves to speed up the reentry of the unemployed to the workforce. Once the economy reaches potential output (and full employment), growth returns to its normal growth path, where the pace of aggregate spending advances in step with the pace of aggregate supply. There is concern that this time the U.S. economy will either not return to its pre-recession growth path but perhaps remain permanently below it, or return to the pre-crisis path but at a slower than normal pace. Problems on the supply side and the demand side of the economy have so far led to a weaker than normal recovery. If the pace of private spending proves insufficient to assure a sustained recovery, would further stimulus by monetary and fiscal policy be warranted? One lesson from the Great Depression is to guard against a too hasty withdrawal of fiscal and monetary stimulus in an economy recovering from a deep decline. The removal of fiscal and monetary stimulus in 1937 is thought to have stopped a recovery and caused a slump that did not end until WWII. Opponents of further stimulus maintain that the accumulation of additional government debt would lower future economic growth, but supporters argue that additional stimulus is the appropriate near-term policy. Moreover, in 2011-2012, the sharply fading effects of fiscal stimulus and weaker growth in Europe have likely dampened economic growth. In regard to the long-term debt problem, in an economy operating close to potential output, government borrowing to finance budget deficits will in theory draw down the pool of national saving, crowding out private capital investment and slowing long-term growth. However, the U.S. economy is currently operating well short of capacity and the risk of such crowding out occurring is therefore low in the near term. Once the cyclical problem of weak demand is resolved and the economy has returned to a normal growth path, mainstream economists’ consensus policy response for an economy with a looming debt crisis is fiscal consolidation—cutting deficits. Such a policy would have the benefits of low and stable interest rates, a less fragile financial system, improved investment prospects, and possibly faster long-term growth. Congressional Research Service Economic Recovery: Sustaining U.S. Economic Growth in a Post-Crisis Economy Contents Background ...................................................................................................................................... 1 Severity of the 2008-2009 Recession ........................................................................................ 1 Policy Responses to the Financial Crisis and Recession ........................................................... 2 Monetary Policy Actions ..................................................................................................... 2 Fiscal Policy Actions ........................................................................................................... 3 A Sustained but Slow Economic Recovery ..................................................................................... 4 The Shape of Economic Recovery................................................................................................... 9 Demand Side Problems?............................................................................................................ 9 Consumption Spending ..................................................................................................... 10 Investment Spending ......................................................................................................... 13 Net Exports........................................................................................................................ 14 Supply Side Problems? ............................................................................................................ 17 Policy Responses to Increase the Pace of Economic Recovery............................................... 20 Fiscal Policy Actions Taken During the Recovery ............................................................ 20 Monetary Policy Actions Taken During the Recovery ...................................................... 22 A Lesson from the Great Depression ................................................................................ 25 Economic Projections .............................................................................................................. 26 Figures Figure 1. Post-War Recessions ........................................................................................................ 2 Figure 2. Output Gap ....................................................................................................................... 4 Figure 3. Monthly Employment Net Gain or Loss .......................................................................... 6 Figure 4. Housing Starts .................................................................................................................. 6 Figure 5. Unemployment Rate ......................................................................................................... 8 Figure 6. Employment Population Ratio ......................................................................................... 8 Figure 7. Household Equity in Real Estate .................................................................................... 11 Contacts Author Contact Information........................................................................................................... 27 Congressional Research Service Economic Recovery: Sustaining U.S. Economic Growth in a Post-Crisis Economy Background Severity of the 2008-2009 Recession The 2008-2009 recession was long and deep, and according to several indicators was the most severe economic contraction since the 1930s (but still much less severe than the Great Depression). The slowdown of economic activity was moderate through the first half of 2008, but at that point the weakening economy was overtaken by a major financial crisis that would exacerbate the economic weakness and accelerate the decline.1 When the fall of economic activity finally bottomed out in the second half of 2009, real gross domestic product (GDP) had contracted by approximately 5.1%, or by about $680 billion.2 At this point the output gap—the difference between what the economy could produce and what it actually produced—widened to an estimated 8.1%. The decline in economic activity was much sharper than in the 10 previous post-war recessions, in which the fall of real GDP averaged about 2.0% and the output gap increased to near 4.0% (see Figure 1). However, the decline falls well short of the experience during the Great Depression, when real GDP decreased by 30% and the output gap probably exceeded 40%.3 As output decreased the unemployment rate increased, rising from 4.6% in 2007 to a peak of 10.1% in October 2009. The U.S. unemployment rate has not been at this level since 1982, when in the aftermath of the 1981 recession it reached 10.8%, the highest rate of the post-war period. (During the Great Depression the unemployment rate reached 25%.) This rise in the unemployment rate translates to about 7 million persons put out of work during the recession. Another 8.5 million workers have been pushed involuntarily into part-time employment.4 The recession was intertwined with a major financial crisis that exacerbated the negative effects on the economy. Falling stock and house prices led to a large decline in household wealth (net worth), which plummeted by over $16 trillion or about 24% during 2008 and 2009. In addition, the financial panic led to an explosion of risk premiums (i.e., compensation to investors for accepting extra risk over relatively risk-free investments such as U.S. Treasury securities) that froze the flow of credit to the economy, crimping credit supported spending by consumers such as for automobiles, as well as business spending on new plant and equipment.5 1 See CRS Report R40007, Financial Market Turmoil and U.S. Macroeconomic Performance, by Craig K. Elwell. Real GDP is the total output, adjusted for inflation, of goods and services produced in the United States in a given year. 3 Data on real GDP are available from the Department of Commerce, Bureau of Economic Analysis, at http://www.bea.gov/national/index.htm#gdp. Size of output gap is based on CRS calculations using Congressional Budget Office estimate of potential GDP, data for which is available at FRED Economic Data, St. Louis Fed, at http://research.stlouisfed.org/fred2/series/GDPPOT. 4 Data on unemployment and employment are available from the Department of Labor, Bureau of Labor Statistics, at http://www.bls.gov/. 5 Data on wealth and financial flows available at the Board of Governors of the Federal Reserve System, at http://www.federalreserve.gov/releases/z1/Current/z1r-5.pdf. 2 Congressional Research Service 1 Economic Recovery: Sustaining U.S. Economic Growth in a Post-Crisis Economy Figure 1. Post-War Recessions Source: U.S. Department of Commerce: Bureau of Economic Analysis. The negative shocks the economy received in 2008 and 2009 were, arguably, more severe than what occurred in 1929. However, unlike in 1929, the severe negative impulses did not turn a recession into a depression, arguably because timely and sizable policy responses by the government helped to support aggregate spending and stabilize the financial system.6 That stimulative economic policies would have this beneficial effect on a collapsing economy is consistent with standard macroeconomic theory, but without the counterfactual of the economy’s path in the absence of these policies, it is difficult to establish with precision how effective these policies were. Policy Responses to the Financial Crisis and Recession Both monetary and fiscal policies as well as some extraordinary measures were applied to counter the economic decline. This policy response is thought to have forestalled a more severe economic contraction, helping to turn the economy into the incipient economic recovery by mid-2009. These policies likely continued to stimulate economic activity into 2012. Monetary Policy Actions To bolster the liquidity of the financial system and stimulate the economy, during 2008 and 2009 the Federal Reserve (Fed) aggressively applied conventional monetary stimulus by lowering the 6 See IMF, World Economic Outlook, October 2009, Chapter 2, at http://www.imf.org/external/pubs/ft/weo/2009/02/ pdf/c2.pdf; Ben J. Bernanke, Semiannual Monetary Policy Report to Congress, before the senate Banking Committee, July 21,2010, http://www.federalreserve.gov/newsevents/testimony/bernanke20100721a.htm; and Alan S. Blinder, After the Music Stopped: The Financial Crisis, The Response, and The Work Ahead, Penguin Press, January 24, 2013, Chapter 8. Congressional Research Service 2 Economic Recovery: Sustaining U.S. Economic Growth in a Post-Crisis Economy federal funds rate to near zero and boldly expanding its “lender of last resort” role, creating new lending programs to better channel needed liquidity to the financial system and induce greater confidence among lenders. Following the worsening of the financial crisis in September 2008, the Fed grew its balance sheet by lending to the financial system. As a result, between September and November 2008, the Fed’s balance sheet more than doubled, increasing from under $1 trillion to more than $2 trillion. By the beginning of 2009, demand for loans from the Fed was falling as financial conditions normalized. Had the Fed done nothing to offset the fall in lending, the balance sheet would have shrunk by a commensurate amount, and some of the stimulus that it had added to the economy would have been withdrawn. In the spring of 2009, the Fed judged that the economy, which remained in a recession, still needed additional stimulus. On March 18, 2009, the Fed announced a commitment to purchase $300 billion of Treasury securities, $200 billion of Agency debt (later revised to $175 billion), and $1.25 trillion of Agency mortgage-backed securities.7 The Fed’s planned purchases of Treasury securities were completed by the fall of 2009 and planned Agency purchases were completed by the spring of 2010. At this point, the Fed’s balance sheet stood at just above $2 trillion.8 (Further monetary policy actions taken to accelerate the pace of economic recovery are discussed later in the report.) Fiscal Policy Actions Congress and the Bush Administration enacted the Economic Stimulus Act of 2008 (P.L. 110185). This act was a $120 billion package that provided tax rebates to households and accelerated depreciation rules for business. Congress and the Obama Administration passed the American Recovery and Reinvestment Act of 2009 (ARRA; P.L. 111-5). This was a $787 billion package with $286 billion of tax cuts and $501 billion of spending increases that relative to what would have happened without ARRA is estimated to have raised real GDP between 1.5% and 4.2% in 2010 but increased real GDP by progressively smaller amounts in the years that followed.9 In terms of extraordinary measures, Congress and the Bush Administration passed the Emergency Economic Stabilization Act of 2008 (P.L. 110-343), creating the Troubled Asset Relief Program (TARP). TARP authorized the Treasury to use up to $700 billion to directly bolster the capital position of banks or to remove troubled assets from bank balance sheets.10 Congress was an active participant in the emergence of these policy responses and has an ongoing interest in macroeconomic conditions. Current macroeconomic concerns include whether the economic recovery will be sustained, reducing unemployment, speeding a return to normal output and employment growth, and addressing government’s long-term debt situation. 7 Agency debt and securities are issued by “government sponsored enterprises” (GSEs), such as Fannie Mae and Freddie Mac. 8 For further discussion of Fed actions in this period, see CRS Report RL34427, Financial Turmoil: Federal Reserve Policy Responses, by Marc Labonte. 9 See CRS Report R40104, Economic Stimulus: Issues and Policies, by Jane G. Gravelle, Thomas L. Hungerford, and Marc Labonte. 10 For more information on TARP, see CRS Report R41427, Troubled Asset Relief Program (TARP): Implementation and Status, by Baird Webel. Congressional Research Service 3 Economic Recovery: Sustaining U.S. Economic Growth in a Post-Crisis Economy A Sustained but Slow Economic Recovery The U.S. economy, as measured by real GDP growth (i.e., GDP adjusted for inflation) began to recover in mid-2009. However, the pace of growth over the next 3½ years was slow and uneven. From the second half of 2009 and through 2010 real GDP increased at an annualized rate of 2.5%. Compared with the early stage of previous post-war economic recoveries, this is a relatively slow pace and much of the economy’s upward momentum at this time was sustained by the transitory factors of inventory increases and fiscal stimulus. Therefore, sustainable recovery would depend on more enduring sources of demand such spending by consumers and businesses reviving to give continued momentum to the recovery. To a degree, this occurred, but the momentum provided has been lackluster, with the pace of growth decelerating to a 1.8% annualized rate, and the output gap remains sizable (see Figure 2), prompting recurring concerns about the recovery’s sustainability. 11 Figure 2. Output Gap Source: U.S. Department of Commerce: Bureau of Economic Analysis. While business investment spending has been relatively strong during the recovery, consumer spending, typically accounting for two-thirds of final demand, has been relatively weak. Moreover, in 2011-2012, the sharply fading effects of fiscal stimulus and weaker growth in Europe have likely dampened economic growth.12 Nonetheless, economic activity in the private economy shows signs of slow but steady improvement. 11 The output gap is a measure of the difference between actual output and the output the economy could produce if at full employment. 12 U.S. Department of Commerce, Bureau of Economic Analysis, National Income and Product Accounts, at http://www.bea.gov/iTable/index_nipa.cfm. Congressional Research Service 4 Economic Recovery: Sustaining U.S. Economic Growth in a Post-Crisis Economy • Credit conditions have improved, making getting loans easier for consumers and businesses, loosening a constraint on many types of credit supported expenditures. The Fed’s January 2013 survey of senior loan officers indicated that, on net, bank lending standards and terms continued to ease during the previous three months and that the demand for commercial and industrial loans had increased.13 • The stock market has rebounded and interest rate spreads on corporate bonds have narrowed. The Dow Jones stock index, which had plunged to near 6500 in March 2009, by early 2013 had regained all of its lost capitalization. Spreads on investment-grade corporate bonds, a measure of the lenders’ perception of risk and creditworthiness of borrowers, have fallen from a high of 600 basis points in December 2008 to near 25 basis points in early 2013.14 • Manufacturing activity has shown steady improvement during the recovery. Through February 2013, output had increased 2.0% over a year earlier. Capacity utilization has risen from a low of 64% in mid-2009 to 78.3% in February 2013. (A capacity utilization rate of 80%-85% would be typical for a fully recovered economy.)15 • From mid-2009 through February 2013, non-farm payroll employment has increased by about 4 million jobs. Monthly gains have been consistently positive since late 2010, but as evidenced by a weak gain of only 88,000 jobs in March 2013, often not at a scale characteristic of a strong recovery. However, for the 12 months ending in March 2013, monthly employment gains have increased; averaging about 160,000 jobs (see Figure 3).16 • The housing sector has recently shown evidence of improving health. Private new housing starts pushed above 900,000 in December 2012, most recently increasing at an annual rate of 917,000 units in February 2013, up from less than 400,000 units during the recession (see Figure 4). Also, house prices have begun to increase, on average, up about 8% over 12 months ending January 2013.17 13 Board of Governors of the Federal Reserve System, Senior Loan Officers Survey on Bank Lending Practices, January 2013, at http://www.federalreserve.gov/boarddocs/SnLoanSurvey/. 14 Spread of 600 basis points is 6%. Data on spreads found at http://www.bloomberg.com/apps/quote?ticker= .TEDSP%3AIND. 15 Board of Governors of the Federal Reserve System, Statistical Release G.17, March 2013, at http://www.federalreserve.gov/releases/g17/. 16 Bureau of Labor Statistics, Labor Force Statistics from the Current Population Survey, March 2013, at http://www.bls.gov/cps/. 17 U.S Census Bureau, New Residential Construction In February2013, joint release, March 19, 2013, at http://www.census.gov/construction/nrc/pdf/newresconst.pdf and S&P Case–Shiller 20-City Home Price Index, available at http://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices/en/us/?indexId=spusacashpidff—p-us. Congressional Research Service 5 Economic Recovery: Sustaining U.S. Economic Growth in a Post-Crisis Economy Figure 3. Monthly Employment Net Gain or Loss Source: U.S. Department of Labor: Bureau of Labor Statistics. Figure 4. Housing Starts Source: U.S. Department of Commerce: Census Bureau. Congressional Research Service 6 Economic Recovery: Sustaining U.S. Economic Growth in a Post-Crisis Economy On the other hand, growth is well below the historical norm for U.S. economic recoveries as persistent sources of economic weakness continue to dampen economic activity. • Pointing to the slow pace of real GDP growth over 3½ years of recovery, the output gap had narrowed to only 5.8% of real GDP (see Figure 2).18 • Consumer spending, the usual engine of a strong economic recovery, remains tepid, generally slowed by households’ ongoing need to rebuild substantial net worth lost during the recession, continued high unemployment and underemployment, and a surge in energy prices in the first half of 2012. • Employment conditions, despite improvement, remain weak. The unemployment rate, which had peaked at 10.0% in October 2009, has edged down to 7.6% in March 2013, but is still high for this stage of the economic recovery (see Figure 5). A considerable share of the improvement in the unemployment rate is not the result of workers finding jobs, but by discouraged workers leaving the ranks of the officially unemployed by leaving the labor force. The employment to population ratio, which is not affected by changes in labor force participation, has remained near its recession low through three years of economic recovery (see Figure 6). 19 This suggests a labor market that, at best, is only “treading water.” • The housing market, although showing signs of revival, is likely to continue to fall short of its typical contribution to economic recoveries. Although the value of household’s financial assets have bounced back since 2009, the value of their real estate assets have not, continuing to dampen consumer spending.20 • Growth in the UK and the Euro area has been weak and fiscal austerity measures to stem the growth of public debt have likely pushed the region back into recession, slowing growth further. Slower growth in this region, a major U.S. export market, has likely transmitted a contractionary impulse to the United States, slowing the pace of the U.S. recovery in 2012 and will likely continue to do so into 2013.21 • Fiscal policy has tightened significantly since 2010, with federal government expenditures contracting 2.8% in 2011 and 2.2% in 2012, and exerting a dampening effect on economic growth.22 The current budget debate points to more fiscal tightening in 2013. 18 CRS calculation from Bureau of Economic analysis data for real GDP and CBO estimate of potential GDP both available from Federal Reserve Economic Data (FRED), St. Louis Federal Reserve Bank, at http://research.stlouisfed.org/fred2/. 19 Bureau of Labor Statistics, Labor Force Statistics from the Current Population Survey, March 2013, http://www.bls.gov/cps/. 20 See Atif Miam and Amir Sufi, Consumers and the Economy, Part II: Household Debt and the Weak Recovery, Federal Reserve Bank of San Francisco Economic Letter, January 18, 2011. 21 International Monetary Fund (IMF), World Economic Outlook, January 2013, at http://www.imf.org/external/pubs/ft/ weo/2013/update/01/index.htm. 22 U.S. Department of Commerce, Bureau of Economic Analysis, National Income and Product Accounts, at http://www.bea.gov/iTable/index_nipa.cfm. Congressional Research Service 7 Economic Recovery: Sustaining U.S. Economic Growth in a Post-Crisis Economy Figure 5. Unemployment Rate Source: U.S. Department of Labor: Bureau of Labor Statistics. Figure 6. Employment Population Ratio Source: U.S. Department of Labor: Bureau of Labor Statistics. Congressional Research Service 8 Economic Recovery: Sustaining U.S. Economic Growth in a Post-Crisis Economy The Shape of Economic Recovery In the typical post-war business cycle, lower than normal growth of aggregate demand during the recession is quickly followed by a recovery period with above normal growth of spending, perhaps spurred by some degree of monetary and fiscal stimulus. The degree of acceleration of growth in the first two to three years of recovery has varied across post-war business cycles, but has been at an annual pace in a range of 4% to 8%.23 This above normal growth brings the economy back more quickly to the pre-recession growth path, and speeds up the reentry of the unemployed to the workforce. Once the level of aggregate demand approaches the level of potential GDP (or full employment), the economy returns to its pre-recession growth path, where the growth of aggregate spending is slower because it is constrained by the growth of aggregate supply, which in recent years is estimated to have been at an annual pace of near 3.0%. (A subsequent section of the report looks more closely at aggregate supply.)24 There is concern, however, that this time the U.S. economy, without supporting stimulus from policy actions, will either not return to its pre-recession growth path, perhaps remain permanently below it, or return to the pre-crisis path but at a slower than normal pace, or worse, dip into a second recession. Below normal growth would almost certainly translate into below normal recovery of employment, whereas a second round of recession could increase the already high unemployment rate. The next sections of this report discuss problems on the supply side and the demand side of the economy that could lead to a weaker than normal recovery. Demand Side Problems? Much of the vigor that occurred on the demand side of the economy in 2009 and 2010 appears to have come from fiscal stimulus and business inventory restocking. Fiscal stimulus and inventory rebuilding are, however, temporary sources of support of aggregate spending. Sooner or later fiscal stimulus falls away. The Congressional Budget Office (CBO) projects that fiscal stimulus peaked in 2010, provided a smaller boost to demand in 2011, and continued to diminish to a negligible force by the end of 2012.25 Inventory building is a self-limiting process that will not go on indefinitely; stock-building was weaker during most of 2011, and despite a stronger turn in late 2011 and early 2012, inventory growth will unlikely continue to have a major positive effect on aggregate demand. A strong recovery of private sector demand, including consumer spending, investment spending, and exports, is required to sustain an economic recovery that brings the economy quickly back to its pre-recession growth path and unemployment rate. However, there are major uncertainties about the potential medium-term strength of each of these components that could dampen aggregate spending and constrain the economy’s ability to generate a recovery period with above normal growth and quickly falling unemployment. 23 Department of Commerce, Bureau of Economic Analysis, at http://www.bea.gov/national/index.htm#gdp. The long-term growth of aggregate supply is determined by the growth in the supplies of capital and labor and on the growth in production technology used to turn capital and labor into goods and services. 25 The Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2012 to 2020, January 2012, at http://www.cbo.gov/publication/42905. 24 Congressional Research Service 9 Economic Recovery: Sustaining U.S. Economic Growth in a Post-Crisis Economy Consumption Spending Personal consumption expenditures historically constitute the largest and most stable component of aggregate spending in the U.S. economy. During the first three post-war decades, personal consumption spending averaged a 62% share of GDP. However, that share rose significantly over the next three decades, averaging about 65% in the 1980s, 67% during the 1990s, and about 70% between 2001 and 2007. The high level of household spending reached during the 2001-2007 expansion is unlikely to reemerge during the current recovery because it was supported by an unsustainable increase in household debt, a decrease in personal savings, ease of access to credit, and lower energy prices. Household Debt In the mid-1980s, after a long period of relative stability at a scale of around 45% to 50% of GDP, the debt level of households began to rise steadily, reaching over 100% of GDP by 2008. Such a substantial rise in the level of household debt was sustainable so long as rising home prices and a rising stock market continued to also increase the value of household net worth, and interest rates remained low, countering the rise in the burden of debt service as a share of income. The collapse of the housing and stock markets in 2008 and 2009 substantially decreased household net worth, which had, by mid-2009, fallen about $16 trillion below its 2007 peak of nearly $67 trillion.26 This near 25% fall in net worth pushed the household debt burden up substantially. Unlike in earlier post-war recoveries, the need of households to repair their damaged balance sheets induced a large diversion of current income from consumption spending to debt reduction.27 Since 2008, households have reduced their outstanding debt about $1 trillion. 28 If debt reduction continues in 2013, it is likely to be a continuing drag on the pace of economic recovery. A substantial rebuilding of household net worth has occurred during the recovery. Through the fourth quarter of 2012, household net worth has increased by about $15 trillion from its 2009 trough, reaching about $66 trillion and recovering nearly 95% of what was lost during the recession. This improvement has occurred largely on the asset side of the household balance sheet and primarily for financial assets due to the rise of the stock market from its low point in early 2009.29 Such gains tend to be concentrated in higher-income households and not a major source of wealth for the average household. Traditionally, rising home equity, largely dependent on the path of house prices, has been the major contributor to household wealth. The rapid rise of home prices during the last economic expansion caused an equally rapid rise in home equity. Consumers borrowed against this equity to fund current spending. With the sharp fall of home prices, home equity was reduced substantially, erasing that source of funding. Home prices are only now beginning to rise and the housing market is expected to remain relatively weak for 26 Board of Governors of the Federal Reserve System, “Flow of Funds Accounts,” Table B.100, March 7, 2013, at http://www.federalreserve.gov/releases/z1/Current/. 27 See Evan Tanner and Yassar Abdih, “Rebuilding U.S. Wealth,” Finance & Development, IMF, December 2009 at http://www.imf.org/external/pubs/ft/fandd/2009/12/tanner.htm. 28 Board of Governors of the Federal Reserve System, “Flow of Funds Accounts,” Table B.100, March 7, 2013, at http://www.federalreserve.gov/releases/z1/Current/z1r-5.pdf. 29 Board of Governors of the Federal Reserve System, “Flow of Funds Accounts,” Table B.100, March 7, 2013, at http://www.federalreserve.gov/releases/z1/Current/z1r-5.pdf. Congressional Research Service 10 Economic Recovery: Sustaining U.S. Economic Growth in a Post-Crisis Economy several more years, slowing the pace of households rebuilding this component of their net worth, and continuing to dampen the pace consumer spending (see Figure 7). 30 In addition to diverting more personal income to saving, a continued weak labor market is likely to dampen income growth and, in turn, slow the recovery of consumer spending. Figure 7. Household Equity in Real Estate Source: Board of Governors of the Federal Reserve System. Credit Conditions Easy credit availability in the pre-crisis economy enabled households to readily borrow against their rising home equity to fund added spending. Financial innovations allowed lenders to keep interest rates low and offer liberal terms and conditions to entice households to borrow. Many believe that credit conditions will remain tighter during the current expansion. Interest rates are still historically low, but banks greatly tightened the terms and conditions of consumer loans during the crisis and recession and have only slowly relaxed them as the recovery has proceeded. While not likely as important a driver of higher savings as high household debt, tighter credit conditions will make it less likely that households will exploit any increase in their home equity to fund current spending, further constraining consumer spending relative to what occurred during the 2001-2007 economic expansion. 30 The standard model of consumer spending used in economic analysis assumes that consumers seek to avoid large swings in their living standards over the course of their lifetimes. Thus as incomes rise and fall both in the short and long term, individuals are expected to vary their saving rate in order to minimize the effect on their consumption. If consumers seek to maintain a fairly stable level of consumption over their entire lives, then the level of consumption at any given point in their lives will depend on their current wealth and some expectation about their income over the rest of their lives. See Annamaria Lusardi, Jonathan Skinner, and Steven Venti, “Saving Puzzles and Saving Policies in the United States,” National Bureau of Economic Research, Working Paper 8237, April 2001. Congressional Research Service 11 Economic Recovery: Sustaining U.S. Economic Growth in a Post-Crisis Economy Personal Saving The U.S. personal saving rate averaged about 10% of GDP consistently through the 1970s, 1980s, and 1990s. Subsequently, the personal saving rate declined sharply, reaching a low of 1.0% by 2005.31 It is likely that the reduction of household saving was in large measure a consequence of the sizable increase in household net worth associated with increased house prices and stock prices occurring at that time. As wealth rose rapidly, it was less urgent to divert current income to saving. The sharp reduction of household net worth during the recent recession dramatically changed the financial circumstances of households, reducing the use of debt-financed spending. The need to repair household balance sheets induced households to pay down debt. The poor prospect for the appreciation of house prices has eliminated the ability to use rising equity as a substitute for saving. In addition, the increase in economic uncertainty in the aftermath of the financial crisis and recession will likely mean that over the medium term, households could continue to be more inclined to save. As the economic decline intensified, the personal saving rate increased, climbing from 3.5% of GDP in 2007 to 6.1% of GDP at the bottom of the recession in 2009.32 However, with economic recovery the personal saving rate has fallen, averaging about 3.8% in 2012. The passing of the dire financial and economic circumstances that prevailed in 2008 and 2009 has likely led to some of the recent moderation in households’ saving behavior. A lower rate of saving enables higher rates of consumption, but it is uncertain that continued fall of the saving rate will be a substantial source of support for current spending by households. Energy Prices A 30% increase in the price of oil from October 2011 through April 2012 adversely affected household budgets and likely contributed to the slow rate of increase in consumer spending over the same period.33 In the short run, the U.S. demand for energy is relatively inelastic, with little curtailment of energy use in the face of the rising price. As households and businesses spend more for energy, which is largely imported, they tend to spend less on domestic output, slowing economic growth.34 Since April 2012, the price of oil decreased and appears to have stabilized at about 10% below this peak. If it remains near the current level, the dampening effect on economic growth is likely to fade. In addition, increasing supplies of shale gas have resulted in lower natural gas prices, which may benefit household budgets. 31 See CRS Report R40647, The Fall and Rise of Household Saving, by Brian W. Cashell. U.S. Department of Commerce, Bureau of Economic Analysis, National Income and Product Accounts, Table 5.1, http://www.bea.gov/national/nipaweb/SelectTable.asp?Selected=N. 33 U.S. Energy Information Administration, Petroleum; Weekly Spot Price, July 2012, at http://www.eia.gov/dnav/pet/ hist/LeafHandler.ashx?n=PET&s=RCLC1&f=D. 34 Research indicates that a $10 increase in the per barrel price of oil sustained for two years is likely to reduce real GDP growth relative to base-line by 0.2 percentage points in the first year and 0.5 percentage points in the second year. See U.S. Energy Information Administration, Economic Effects of High Oil Prices, 2006, http://www.eia.gov/oiaf/aeo/ otheranalysis/aeo_2006analysispapers/efhop.html. 32 Congressional Research Service 12 Economic Recovery: Sustaining U.S. Economic Growth in a Post-Crisis Economy Slow Recovery of Consumer Spending? If consumer spending continues its slow paced recovery, then for the U.S. economy to return to its normal pre-crisis growth path, an improved pace of GDP growth will have to come from other components of aggregate demand: investment spending, net exports, or government spending. Investment Spending Investment spending is the third-largest component of aggregate spending, historically averaging 17% to 18% of GDP in years of near normal output growth. (Government spending is second largest at about 20%.) Historically, the largest portion of total investment spending is business fixed investment, its share averaging 11% to 12% of GDP in periods of normal growth. The second component of total investment is residential investment (i.e., new housing), averaging 4% to 5% of GDP. Investment spending is very sensitive to economic conditions and more volatile than consumer spending. This sensitivity is at least in part because investment projects are often postponable to a time when economic conditions are more favorable. Its volatility makes investment spending an important determinant of the amplitude, down and up, of the typical business cycle.35 As aggregate spending fell and credit availability tightened in 2008, investment spending quickly weakened. As a share of real GDP, investment spending fell from about 16% in 2007 to about 11% at the economy’s trough in 2009. The sharp fall in real GDP from the second quarter of 2008 through the first quarter of 2009 was nearly fully accounted for by the sharp fall of investment spending over this same period. Throughout the economic recovery, investment spending has been a leading source of economic growth, elevating its share of real GDP to 12.7% in 2010, 13.5% in 2011, and 14% in 2012.36 In particular, the equipment and software component of nonresidential investment has been the principal source of business spending strength and an important contributor to the pace of the economic recovery. Equipment and software spending increased 14.6% in 2010, contributing nearly a full percentage point to the growth of real GDP in that year. This category of business investment spending continued to be an important source of economic growth in 2011, increasing at an annual rate of 11.0% and contributing 0.7 percentage points to real GDP growth. However, in 2012, investment spending on equipment and software slowed, advancing at a 6.9% annual rate and contributing 0.5 percentage points to real GDP growth.37 Typically, this same sensitivity also works in the opposite direction. Strongly rising investment spending, responding to improving market demand, reduced uncertainty, and expanding credit availability, often gives an above normal contribution to the rebound of aggregate spending during the recovery phase of the business cycle. Looking forward, however, some significant constraints on both residential and business investment raise uncertainty about whether investment spending will continue to be a strong 35 Ibid., Table 1.1.5. Department of Commerce, Bureau of Economic Analysis, National Income and Product Accounts, Table 1.1.5, athttp://www.bea.gov/national/index.htm#gdp. 37 Ibid., Table 1.1.5, at http://www.bea.gov/national/index.htm#gdp. 36 Congressional Research Service 13 Economic Recovery: Sustaining U.S. Economic Growth in a Post-Crisis Economy contributor to economic recovery, and therefore, whether it could be a component of aggregate spending capable of compensating for a weaker than normal recovery of spending by consumers. The principal constraint on residential investment has been the large inventory of vacant housing, left over from the 2002-2006 housing boom. It is estimated that the number of vacancies could be more than 2 million units above what would normally be expected at this stage of the business cycle.38 As discussed above, the housing market has recently shown signs of stabilizing, and residential investment spending has risen strongly in 2012, albeit from a very low base. On balance new house construction is likely to remain relatively weak for the next two years while the inventory overhang continues to be worked down. The prospect for nonresidential investment is likely to be better than for residential investment, but it is not clear that with economic recovery nonresidential investment will exceed its pre-crisis level. On the supply side, capacity utilization rates have climbed back from record lows of below 70% reached during the recession, but, at about 78% currently, are still only near the lows reached in the 1990 and the 2001 recessions and well short of the 80% to 85% that would typically correspond to operating near or at capacity.39 On the demand side, business investment in new plants and equipment is most often a response to the expectation of increased demand for the products they produce. The main driver of that demand is consumer spending and, as discussed above, that spending has been tepid, with the not unlikely prospect that it may continue to be weak over the near term if households have made a lasting commitment to increased savings. Stronger foreign demand could also stimulate investment spending and in theory compensate for the weaker pull of domestic demand, but as discussed more fully below, foreign demand may also be weak. Also, problems in the financial sector have caused sharply reduced activity in commercial real estate, contributing to persistent weakness in business investment spending on structures.40 In general, it seems questionable whether total investment spending would provide the offset to a below normal contribution of consumption spending to economic growth over the near term. Net Exports The U.S. trade deficit (real net exports) shrank from about 6% of real GDP in 2006 to below 3% in 2009. Since the beginning of the recession in late 2007 through the end of the contraction in mid-2009, net exports have made a significant positive contribution to real GDP in an otherwise declining economy. Even as economic weakness abroad caused U.S. exports to fall, imports fell by more, providing a net positive push to current economic activity.41 38 U.S. Census Bureau, Housing Vacancies and Home Ownership, at http://www.census.gov/hhes/www/housing/hvs/ historic/. 39 Data for capacity utilization are available at Board of Governors of the Federal Reserve System, Industrial Production and Capacity Utilization, Table G17, http://www.federalreserve.gov/releases/g17/. 40 Bureau of Economic Analysis, National Income and Product Accounts, Table 1.1.5, at http://www.bea.gov/national/ index.htm#gdp. 41 Department of Commerce, Bureau of Economic Analysis, National Income and Product Accounts, Table 1.1.6, at http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1. Congressional Research Service 14 Economic Recovery: Sustaining U.S. Economic Growth in a Post-Crisis Economy The 3 percentage point swing in real net exports is, however, largely the consequence of the severe economic weakness in the United States over this period. Since mid-2009, the deficit in net exports has decreased very little, falling slightly to 2.9% of real GDP in 2012. This relatively flat performance means that over the course of the current recovery net exports have not had either a substantial positive or negative impact on economic growth. This neutral pattern makes it uncertain that net exports can be expected to boost aggregate spending sufficiently to offset weak consumption over the medium term and help assure a sustained recovery at a pace that steadily reduces unemployment. Boosting U.S. Net Exports Through a Rebalancing of Global Spending Increasing U.S. net exports to any degree requires that the trade deficit continues to decrease. For that to happen, trade surpluses of the rest of the world with the United States must also decrease. To achieve this adjustment of trade flows, a sizable rebalancing of domestic and external demand on the part of the deficit and surplus economies would need to occur.42 Because a trade deficit is a consequence of an economy spending more than it produces, rebalancing in this circumstance requires a decrease of domestic spending and increase of domestic saving. In contrast, for overseas trade partners, because a trade surplus is a consequence of an economy spending less than it produces, rebalancing in this circumstance requires an increase of trade partner domestic spending and decrease in trade partner domestic saving. This rebalancing of spending will put pressure on the dollar to depreciate and foreign currencies to appreciate. A fall in the value of the dollar relative to the currencies of the surplus countries causes the price of foreign goods to rise for U.S. buyers and the price of U.S. goods to fall for foreign buyers. This change in the relative price of foreign versus domestic goods will cause the net exports of the United States to rise, giving the boost in spending needed to potentially offset reduced consumption spending. The change in relative prices would also cause the net exports of surplus countries to fall as more of current output is absorbed by increased domestic spending. In the United States, as discussed above, some measure of rebalancing seems to be occurring, as evidenced by the increase in the personal saving rate above its pre-recession low. Although there are good reasons to expect this increase to be sustained, there is the possibility that households would eventually revert to their pre-crisis low saving patterns. However, even if household saving remains higher, it is likely that any significant increase in the overall U.S. national saving rate would also require an increase in government saving via smaller federal budget deficits. Large U.S. budget deficits over the near term are providing a needed boost to weak aggregate spending during the early stages of an economic recovery. With the strengthening of private spending as the recovery matures, large government budget deficits would fade away, causing government saving to rise. What puts this fading away of budget deficits in doubt over the long term is the prospect of having to fund the obligations attached to the rising demand of an aging U.S. population for healthcare, Social Security, and other entitlements. Without policy actions to address these long-term demands, it is not clear how the long-term budget deficits will fall. 42 On global rebalancing, see for example, Olivier Blanchard, “Sustaining Global Recovery,” International Monetary Fund, September 2009, “Rebalancing,” The Economist, March 31, 2010, at http://www.imf.org/external/pubs/ft/fandd/ 2009/09/index.htm, and Board of Governors of the Federal Reserve System, Vice-chairman Donald L. Kohn, Speech “Global Imbalances,” May 11, 2010, at http://www.federalreserve.gov/newsevents/speech/kohn20100511a.htm. Congressional Research Service 15 Economic Recovery: Sustaining U.S. Economic Growth in a Post-Crisis Economy Effective global rebalancing arguably also involves sizable adjustments by the largest surplus economies—Germany, Japan, and China. However, there are significant potential constraints on how substantially each of these three economies can “save less and spend more,” perhaps limiting any sizable appreciation of their currencies relative to the dollar, and any associated boost in U.S. net exports. The inability of Germany to move its exchange rate independently from the other Euro area economies reduces its flexibility of adjustment. In addition, the effects of the 2008-2009 recession have left limited room for further fiscal expansion and small ability to lower the household saving rate. In addition, the ongoing sovereign debt crisis in the euro area has dampened growth prospects in Germany, likely weakening the demand for U.S. exports. Although its level of debt is not high, recent German policy actions have stressed fiscal consolidation, tending to increase saving and dampen spending.43 Japan, which does have a very high level of public debt, has little to no room for fiscal expansion and a poor prospect of boosting household spending. Moreover, both Germany and Japan, faced with substantial near-term economic weakness in the aftermath of the global recession, may take steps to avoid the dampening of their net exports that a sizable appreciation of the exchange rate would cause. China has the largest bilateral trade surplus with the United States and therefore has the potential to have a large impact on U.S. export sales and through that a significant positive impulse on the pace of the U.S. economic recovery. Also, economic growth has remained relatively strong in China through the recent global financial crisis and recession, and aggregate demand is expected to be strong through the next two to three years. What is uncertain, however, is whether a greater share of this spending will be domestic demand, particularly consumption spending by Chinese households. The very high rate of saving by Chinese households is thought to be a precautionary measure to compensate for a lack of social insurance. It likely also reflects limited access to consumer credit. The difficulty for the near-term task of sustaining economic recovery is that even if policy actions are taken to remove these constraints on consumer spending, households are likely to only gradually change their pattern of consumption and not provide a sharp near-term boost to domestic spending. Also, a closer look at the sources of increase in China’s domestic saving over the last decade reveals that the principal contributor to that growth was Chinese companies, not households. Therefore, changing the saving practices of Chinese companies is likely to be an important aspect of any large increase in China’s saving rate. It is argued by some that Chinese companies retain too large a share of their earnings. Better access to credit and changes in the governance rules of Chinese business would likely reduce the business saving rate. But, as with households, even if such policy initiatives are forthcoming, the change in the business saving rate is likely to emerge only gradually.44 43 OECD, Restoring Public Finances, Country Notes: Germany, 2010, at http://www.oecd.org/gov/ budgetingandpublicexpenditures/47840777.pdf. 44 Of course, for these reforms to translate into a shift in China’s trade balance, that nation must be willing to allow its’ exchange rate to rise relative to the dollar, causing a decrease in the price of foreign goods relative to domestic goods, and exerting downward pressure on China’s trade surplus. From July 2005 to February 2009, China abandoned its dollar peg, allowing the yuan to appreciate by 28% (on a real trade-weighted basis). However, faced with weakening export sales due to the global financial crisis China for the last 10 months has re-pegged the yuan to the dollar. China’s export-led growth model, relying on a high saving rate (to keep internal demand low) and a low exchange rate pegged (continued...) Congressional Research Service 16 Economic Recovery: Sustaining U.S. Economic Growth in a Post-Crisis Economy Even with a successful rebalancing, it is unlikely that China alone can propel a boost in U.S. net exports sufficient to offset weak domestic demand and pace economic recovery. China’s global trade surplus is estimated to be about 10% of GDP. However, China is only about one-third the size of the U.S. economy. Therefore, if China’s trade were only with the United States, it would have to reduce its trade surplus by 3% of GDP to effect a 1 percentage point reduction of the U.S. trade deficit. But since, in fact, only about 16% of China’s trade is with the United States, it would take a 15 percentage point change in China’s trade balance (moving from a surplus equal to 10% of GDP to a deficit equal to 5% of GDP) to reduce the U.S. trade deficit by 1 percentage point. (This assumes that the fall of China’s trade surplus is not offset by an increase of other trading partners’ surpluses.) Other emerging Asian economies also run trade surpluses, and adding these to the calculation makes the relative scale of rebalancing needed to achieve a given amount of improvement in the U.S trade deficit more feasible. However, all of emerging Asia is only about half the size of the U.S. economy. Therefore, if the U.S. share of the whole region’s trade is similar to China’s, emerging Asia would need to accomplish a sizable 7 percentage point change in its trade balance to generate a 1 percentage point change in the U.S. trade balance. As with China, for a reduction of the trade surpluses of other emerging Asian economies to happen quickly, their currencies will need to appreciate against the dollar. All in all, there are reasons to doubt whether U.S. net exports can increase over the near term at a pace sufficient to fully compensate for the prospect of slower than normal growth of other components of U.S. domestic spending. Supply Side Problems? The supply side of the economy governs its capacity for producing goods and services. That capacity is a function of the economy’s supplies of labor and capital and the level of technology used to turn labor and capital into the output of goods and services. In the short run, the potential supplies of these productive factors are relatively fixed and will determine the economy’s potential output. In periods of economic slack, rising aggregate demand can increase the economy’s output and employment up to the level of potential output, which corresponds with full employment. In the long run, as the supplies of capital and labor and the level of technology increase, the level of potential output also increases. Over time the steady rise of potential output will define the economy’s long-term growth path (called the “trend” growth rate). When aggregate demand is below potential output the economy can grow faster than trend growth, but when the level of aggregate demand reaches the level of potential output, further growth of output will be constrained to the trend growth rate. Typically the long-run growth path is thought to be relatively stable and not greatly affected by recessions and the associated short-term fluctuations in aggregate demand. Over the post-war (...continued) to the dollar (to keep external demand high), has been very successful and, despite the possible advantages of reforms to boost domestic demand, it is uncertain whether China would move substantially away from this model. Congressional Research Service 17 Economic Recovery: Sustaining U.S. Economic Growth in a Post-Crisis Economy period, the average annual growth rate of potential output for the United States has been 3.4%; however, since the 1970s it has averaged closer to 3.0%.45 An analysis by the International Monetary Fund (IMF) examines the question of whether output will return to its pre-crisis trend.46 It examines the medium-term and long-run paths of output after 88 banking crises over the past four decades in a wide range of countries (including both advanced and developing economies). A key conclusion was that seven years after the crisis, output had declined relative to trend by nearly 10% for the average country. But there was considerable variation of outcomes across crisis episodes. In other words, such crises not only reduce actual output, but also may reduce potential output (the economy’s structural and institutional capacity to produce output). In this circumstance, the economy could return to its trend growth rate, but there is unlikely to be a rebound period of above normal growth to quickly return the economy to its pre-crisis potential output and growth path and, in turn, quickly reduce unemployment. This failure to return to the pre-crisis potential output means that the economy bears the burden of a permanent output loss and the large initial increase in the unemployment rate caused by the crisis could persist even as the economy is growing at its trend rate. The IMF analysis suggests that the reduction of the post-crisis growth path is likely to be the consequence of decreases of approximately equal size in the employment rate, the capital-labor ratio, and productivity. The adverse effect of the financial crisis on the employment rate is thought to arise from an increase in the “structural unemployment rate,” hampering the post-crisis economy’s ability to accomplish the needed reallocation of labor from sectors that have contracted permanently to sectors that are expanding. Because the aftermath of the crisis will likely involve sizable changes in the composition of the economy, it likely also increases the mismatch between the skills of the unemployed and the skills demanded in the post-crisis labor market—job vacancies go unfilled for lack of a worker with sufficient skills for the job.47 Also, labor force participation rates may fall if the crisis is severe enough to substantially increase the numbers of the long-term unemployed, some of whom may become discouraged from searching for a new job. A crisis-induced fall of house prices and a rising incidence of mortgages with negative equity will also discourage the geographic mobility of workers who are unable to sell their houses. The adverse impact of a financial crisis on capital accumulation is likely the combined outcome of several factors. Decreased demand for products and heightened uncertainty of potential return dampens the incentive to invest. In addition, the financial crisis could impede the process of 45 The Congressional Budget Office, Key Assumptions in Projecting Potential Output, August 2012, at http://www.cbo.gov/publication/43541. 46 P. Kannan, A. Scott, and M. Terrones, “From Recession to Recovery: How Soon and How Strong?,” in World Economic Outlook, International Monetary Fund, April 2009, pp. 103-138. Also see Davide Furceri and Annabelle Mourougane, The Effect of Financial Crisis on Potential Output: New Empirical Evidence from OECD Countries, OECD Economics Department, Working Paper no. 699, May 2009. 47 Employment in construction, financial services, and some types of manufacturing may remain depressed for some time, requiring some who lose their jobs in those sectors to seek employment in other sectors. See also CRS Report R41785, The Increase in Unemployment Since 2007: Is It Cyclical or Structural?, by Linda Levine, which suggests that most of current U.S. unemployment is cyclical. Congressional Research Service 18 Economic Recovery: Sustaining U.S. Economic Growth in a Post-Crisis Economy financial intermediation for up to several years, as weakened balance sheets, lower collateral values, and elevated risk premiums slow the flow of credit and elevate the real cost of borrowing. The dampening effect on productivity may occur as higher risk premiums and a generally more cautious approach to spending by businesses diminish the willingness and ability to finance relatively high-risk projects. Expenditures on research and development are typically pro-cyclical and likely to be sharply reduced in times of crisis. Productivity tends to recover quickly after recessions and thus allows the economy to resume growth at the pre-crisis trend rate. However, the capital and employment losses tend to endure and keep the economy on a lower growth path. Has the recent financial crisis caused a reduction in the potential output of the U.S. economy and placed it on a lower trend growth path? It is difficult to make a concurrent determination because potential output is not directly observable, and can only be imputed from the economy’s actual post-crisis performance. A clear determination of any such permanent output loss is some years in the future. Although the IMF study gives reasons why the financial crisis possibly could have adversely affected the economy’s supply side, the study also finds that there can be some significant mitigating factors that could be particularly relevant for the U.S. economy. First, a high pre-crisis investment share is a good predictor of a large potential output loss. This is a reflection of the high sensitivity of investment to the negative effects of a financial crisis. For the United States there was no sharp increase in investment spending above trend as measured as a share of GDP for the three years prior to the financial crisis, averaging near a typical 16% of GDP.48 Second, the IMF study also found that those economies that aggressively apply stimulative fiscal and monetary policies during the crisis tend to have smaller medium-term output losses. As already discussed, the United States has applied quickly and substantially stimulative polices in response to the financial crisis. Third, countries with fewer labor market rigidities suffered smaller medium-term output losses. U.S. labor markets, as compared with other advanced economies, are relatively free of labor market rigidities, though as mentioned declining house prices may have reduced mobility of some workers who own their own homes. The Congressional Budget Office (CBO) currently projects U.S. potential output to increase at an annual average rate of 2.2% for the 2013-2018 period, the same pace as during the 2002-2012 period. CBO’s projected rate of growth of potential output is well below the post-war average of 3.3%. Slower growth of potential GDP is largely the consequence of a projection of significantly slower labor force growth than during the post-war period in the coming decades. Most of the slowdown in labor force growth is related to long-term demographic changes forced by an aging population; however, a protracted recession with growing numbers of long-term unemployed and discouraged workers has also contributed to this labor force dynamic.49 48 Department of Commerce, Bureau of Economic Analysis, National Income and Product Accounts, Table 1.1.6, at http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1. 49 The Congressional Budget Office, Budget and Economic Outlook: An Update, August 2012, Table 2-3, at http://www.cbo.gov/doc.cfm?index=12316. Congressional Research Service 19 Economic Recovery: Sustaining U.S. Economic Growth ...
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