The limp economic recovery, five years on

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Article Highlights

  • Economic growth has been weak compared to other post-WWII recoveries.

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  • Nearly five years after the crash, why hasn't the economy fully recovered?

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  • Fed is offering little relief for deflation and disinflation.

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Key points:

  • Economic growth since the end of the 2008 financial crisis has been considerably below the average of other post–World War II recoveries.
  • Weak growth of investments and employment and slow turnaround of consumption spending have contributed to the troubling pace of this recovery.
  • To elevate and sustain growth, the US government must reverse disinflation before it becomes deflation, reduce marginal tax rates on capital accumulation, and provide clear leadership that focuses on building opportunity.

 

Wags have applied the term “electile dysfunction” to characterize John Boehner’s weak performance as House majority leader. But it may be a more apt characterization of the impact of this flaccid economic recovery on Democrats’ reelection chances in the November midterm elections. Talk of better times notwithstanding, a closer examination of this recovery, which will be five years old in June, provides a clear picture of why it has been so disappointing.

Weak Growth

Growth since the June 2009 trough of this recovery has been considerably below average when compared to post–World War II recoveries. Figure 1 (red line) shows this recovery compared to other recoveries. The black line is the average growth rate during the five years after a trough in business cycles since 1947. The dashed lines are the standard deviation around that average. As is clear from a close look at the red line, growth in the current recovery has been below average for every quarter save two. The red line ends in the first quarter of 2014, which is currently estimated to be at growth of 1 percent.

Figure 1. Real Gross Domestic Product Growth
Source: US Department of Commerce, Bureau of Economic Analysis

Of course, overall growth is made up of the growth of its components—consumptions, investment, and net imports. It is also important to remember that the subpar growth over the last five years has occurred at the same time that unprecedented monetary and fiscal stimulus has been applied to support the economy. However, since the end of last year, both fiscal and monetary stimulus are being withdrawn. Notwithstanding optimistic forecasts of 3 percent growth starting at the middle of this year, it remains to be seen how robust growth can be without the help of the extraordinary monetary and fiscal stimulus that has characterized the last half-decade.

Weak Investment

One of the most important characteristics of a robust recovery is robust investment growth. After a typical recession, with inventories depleted and demand rising, most producers wish to add to their capital stock to meet expected higher aggregate demand. The rise in investment often accompanies an improvement in animal spirits, or optimism, among producers and also may lead to further increases in investment through the so-called accelerated effect.

This recovery is a disappointing exception to the rule. As figure 2 shows, investment during the recovery, since June 2009, has run far below the average pace shown by the black line and is virtually identical to the dotted line—a full standard deviation below the typical investment growth pattern during a recovery.

Figure 2. Real Private Nonresidential Fixed Investment
Source: US Department of Commerce, Bureau of Economic Analysis

Explanations for the weak growth in investment abound. Investor uncertainty has risen in the wake of the financial crisis and substantial regulatory changes by the Obama administration, particularly in the areas of health care and financial services. This heightened investor uncertainty has penalized investment growth. Notwithstanding substantial monetary and fiscal stimulus through 2012, growth of aggregate demand has been weak, so investors have not felt the need to add to the capital stock to meet this weak growth both in the US and abroad.

The weakness of investment is especially disappointing given that real interest rates, one of the determinants of investment, have been either zero or negative for most of the period since 2009. Normally, extraordinarily low borrowing costs would encourage investors to add to their capital stock. But during this expansion, the level of uncertainty has been high enough and the level of aggregate demand weak enough to discourage investment above minimal levels. Although many analysts, including the Federal Reserve, have been calling for an investment rebound for over a year, as is clear from figure 2, investment continues to crawl along at the bottom of the range for post-WWII recoveries.

Of course, another problem for investment is the classic symptom of excess supply that has shown up in the behavior of price level. Inflation has been slowing over the past several years, indicating weak aggregate demand and ample productive capacity that have combined to weaken investment spending. Producers are not eager to add to capacity when the outlook for prices that they can charge for the goods they produce is bleak.[1]

Figure 3 shows the substandard path of inflation during this recovery. Indeed, deflation may be more of a threat than inflation to the future paths of the US and global economies.

Figure 3. Inflation Calculated as the Year-over-Year Change in Monthly Urban Consumer Price Index

Source: US Department of Commerce, Bureau of Economic Analysis

Consumption and Wealth

Another striking feature of this weak recovery has been the slow recovery of consumption spending by households, especially in view of the substantial increase in wealth that has occurred with the recovery of the stock market and the housing market. Some recovery in the stock market since 2009 and the subsequent rise in house prices since 2011 has increased total household wealth by about $25 trillion over the past several years.

Normally, about 4 percent of the rise in household wealth, an important determinant of consumption, is spent. That would mean an increase in spending attributable to the wealth effect equal to about $1 trillion. Spread over five years, that would provide $200 billion per year of extra demand growth, which would show up as stronger consumption spending. Demand growth of $200 billion a year is substantial, as it adds about 1.25 percentage points of growth per year, other things being equal. Given the average growth over the past five years has been about 2.2 percentage points without the wealth effect, growth would have been truly tepid, at about a 1 percent annual pace.

Figure 4 shows the path of real consumption expenditures during this expansion. Notwithstanding wealth effects, consumption has been more than a standard deviation below the typical level over most of the expansion, accounting for the widely noted weakness in aggregate demand. The persistence of weak demand growth, even with substantial help from monetary and fiscal stimulus, suggests that the aftermath of the financial crisis has left households with a strong preference for cash and liquid assets. Indeed, part of the weakness of consumption reflects the efforts of households to rebuild balance sheets through extra saving after the devastation of the 2008 financial crisis.

Figure 4. Real Personal Consumption Expenditures
Source: US Department of Commerce, Bureau of Economic Analysis

The volatile path of the wealth effect is clear from figure 5. After a massive drop in wealth in the midst of the 2008 crisis, the percentage increase in wealth has been substantial and rapid compared to past expansions. The percentage rise in household real net worth since about 2011 has been a brisk 12 percent, leading some to observe that the wealth effect must be growing weaker in the light of the weak consumption growth that has accompanied the rapid increase of wealth.

Figure 5. Year-over-Year Change in Real Net Worth of Household and Nonprofit Organizations

Source: Board of Governors of the Federal Reserve System

Part of the mystery regarding the weak connection between wealth and consumption is explained in figure 6, which shows the level as opposed to the growth of household real net worth over the past cycle. It is clear that the financial crisis induced a drop of household real net worth of about 25 percent over the two years prior to the cycle trough in 2009. Since then, while wealth has been rising, it just, early in 2014, reattained its precrisis level. The fact that it has required seven full years for households to regain levels of net worth last seen in 2007 probably has left them cautious and helped to account for the weak performance of consumption over this feeble expansion.

Figure 6. Real Net Worth of Household and Nonprofit Organizations, Level

Source: Board of Governors of the Federal Reserve System

A Labor-Unfriendly Expansion

The recent expansion has been characterized by especially weak growth of employment and persistence of high unemployment, notwithstanding some progress over the past year. (See figure 7.) Companies have been less than eager to add to their capital stock, and they have also been less than eager to restore levels of employment lost during the financial crisis. Part of the reason may be numerous innovations embodied in labor-saving technologies that reduce the need for labor in the production process. The ability to use smartphones and tablets to manage communication and scheduling without a human assistant come to mind.

Figure 7. Civilian Unemployment Rate

Source: US Department of Labor, Bureau of Labor Statistics

Surely, unit labor costs, the difference between real wages and productivity growth over the past cycle, have increased at a very slow pace, about equal to a level a full standard deviation below the level that is normal for postwar expansion. (See figure 8.) Labor-saving technology has enabled firms to expand at a pace sufficient to keep up with tepid aggregate demand growth, using the existing capital stock and less labor. The result has been a shift in income distribution away from labor and toward capital during much of this expansion.

Figure 8. Nonfarm Business Sector: Unit Labor Cost
Source: US Department of Labor, Bureau of Labor Statistics

Many of the rents attributable to the expansion and the role played by new electronic devices have been captured by the developers of those new technologies. Internet moguls and Silicon Valley billionaires come to mind. In short, some of the biggest winners during this expansion have been the owners of new labor-saving technologies that have enabled firms to continue to expand output with only modest levels of investment.

Looking Ahead

Given the substandard expansion so far, the important question is what will happen to the expansion in the coming months and years and what can be done to improve the chances that growth will accelerate to a level that substantially reduces the rate of unemployment while avoiding inflation.

Bear in mind that the average postwar expansion lasts 58 months, which would take us to April of this year from the June 2009 trough. That is, already this expansion has lasted longer than the average postwar expansion, no doubt with some help from substantial monetary and fiscal stimulus.

Figure 9. Length of Economic Expansions (in Months)
Note: Adapted from a chart in Josh Zumbrun, "Sluggish Economic Recovery Proves Resilient," Wall Street Journal. April 20, 2014.
Sources: National Bureau of Economic Research, Congressional Budget Office, Federal Reserve Summary of Economic Projects


Growth in the first quarter of 2014, however, looks to be about 1 percent, as figure 1 shows. The Fed and consensus are predicting 3 percent growth for 2014. If growth is 1 percent during the first quarter, it will have to average about 3.7 percent, substantially above the 2 percent trend, per quarter for the balance of the year to achieve an average 3 percent growth rate for 2014. Given the absence of a substantial recovery in consumption and investment to date, that may be wishful thinking.

The wealth effect that added about 1.2 percentage points to growth annually over the past five years may level off this year. The stock market is essentially flat on the year, while the housing sector shows signs of cooling. Absent the wealth effect, other traditional growth sources like consumption, spending, net exports, and investments will have to take up the slack. So far, as noted, investment has been disappointing and consumption spending has grown at about a 2 percent pace, which may slow further if the wealth effect atrophies.

The outlook for net exports is not particularly bright, especially in view of weak growth in Europe and weakening growth in China. While many analysts have suggested that the slow growth rate during the first quarter of 2014 is largely due to unusually cold weather, it remains to be seen whether the drag from atrophy of the wealth effect will offset the spending and growth boost from warmer weather. Remember, too, that the Fed is on a modest tightening path, with a steady reduction of asset purchases and hints that rate increases may begin in March 2015, sooner than had been expected six months ago. The budget deficit is actually falling at a faster-than-expected pace, which is good news for the fiscal outlook, though it is a drag on growth.

The recipe for a stronger expansion includes several elements. First, steady disinflation must be reversed well before it turns into deflation. So far, the Fed has taken little notice of disinflation as a serious problem and, of course, has taken no steps to offset it.

Also needed to help elevate and sustain growth is corporate tax reform that lowers marginal tax rates on capital accumulation. The tax reform plan suggested by House Ways and Means Chairman Dave Camp (R-MI) provides an excellent outline for tax reform, including substantial reduction of tax rates on households offset by additional revenues from closing loopholes.

But something additional is needed to sustain a stronger recovery in the United States—leadership. In a recent article in the Wall Street Journal, George Osborne, United Kingdom chancellor of the Exchequer, laid out a positive vision that would be a substantial help if it were repeated here in the United States. Said Osborne,

Some say that if there are people lacking work, the government should create jobs itself through more spending. If we want a more equal society, they say, the answer is a bigger welfare budget. I say the answer is to make sure that work pays by cutting taxes on work and reforming welfare; to reduce business taxes and regulatory barriers that hold back employment creation; and—most critically—to make sure that we have the best schools, skills and science in the world. In other words, to build a ladder of opportunity for people to climb.[2]

Unfortunately, American leadership at the White House and the Treasury Department continues to press for an enlarged government role in creating jobs. Regulation remains substantial and burdensome, and the uncertainties attached to the new health care system impede growth especially among America’s smaller businesses. The subpar investment recovery during this expansion speaks for itself. Producers are simply not willing to add substantially to capacity, given the uncertainties attached to the prospective after-tax returns to such investment. Disinflation and the threat of deflation have also discouraged investment, and the Fed is offering little relief.

The global economy is not providing a substantial boost for the US economy in 2014. European growth is tepid at best and impeded by steady disinflation and difficulties with the European banking system. Chinese growth is substandard as China adjusts to a new, less-ambitious phase in its prospective growth path.

The November midterm elections may provide some relief insofar as a sharp repudiation of the bad economic policy emanating from the White House may manifest itself in Republican control of both the House and the Senate. That outcome would be a strong signal to leadership in Washington that a different tack is required to produce a sustainable recovery. A substandard recovery lasting more than five years surely needs some extra help in the form of more inspiration and less drag from Washington.

Notes
1. See John H. Makin, “Now Is the Time to Preempt Deflation,” AEI Economic Outlook (April 2014), www.aei.org/outlook/economics/international-economy/now-is-the-time-to-preempt-deflation/.
2. George Osborne, “What the Economic Pessimists Are Missing,” Wall Street Journal, April 10, 2014.

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John H.
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