BERKELEY – The United States continues to recover from its deepest economic slump since the Great Depression, but the pace of recovery remains frustratingly slow. There are several reasons to anticipate modest improvement in 2013, although, as usual, there are downside risks.
Prolonged recession or a financial crisis in Europe and slower growth in emerging markets are the main external sources of potential danger. At home, political infighting underlies the two greatest risks: failure to reach a deal to raise the debt ceiling and an additional round of fiscal contraction that stymies economic growth.
Since 2010, tepid average annual GDP growth of 2.1% has meant weak job creation. In both this recovery and the previous two, the rebound in employment growth has been weaker and later than the rebound in GDP growth. But the loss of jobs in the most recent recession was more than twice as large as in previous recessions, so a slow recovery has meant a much higher unemployment rate for a much longer period.
Weak aggregate demand is the primary culprit for subdued GDP and employment growth. The 2008 recession was triggered by a financial crisis that erupted after the collapse of a credit-fueled asset bubble decimated the housing market. Private-sector demand contracts sharply and recovers only slowly after such crises. The private-sector financial balance swung from a deficit of 3.7% of GDP in 2006, at the height of the boom, to a surplus of about 6.8% of GDP in 2010 and about 5% today. This represents the sharpest contraction and weakest recovery in private-sector demand since the end of World War II.
Growth in two components of private demand, residential investment and consumption, which account for more than 75% of total spending in the US economy, has been especially slow. Both sources of demand are likely to strengthen in 2013.
Residential investment is still at an historic low as a share of GDP as a result of overbuilding during the 2003-2008 housing boom and the tsunami of foreclosures that followed. But the headwinds in the housing market are dissipating. Home sales, prices, and construction all rose last year, while foreclosures declined. Residential investment should be a source of output and job growth this year.
Large losses in household wealth, deleveraging from unsustainable debt, weak wage growth, and a decline in labor’s share of national income to a historic low have combined to constrain consumption growth. Real median household income is still nearly 7% below its 2007 peak, real median household net worth dropped by 35% between 2005 and 2010 (and remains significantly below its pre-recession peak), and about 90% of the income gains during the recovery have gone to the top 1%.
To be sure, the balance-sheet headwinds holding back consumption have eased. Households have slashed their debt – often through painful foreclosures and bankruptcies – and their debt relative to income has sunk to its 2005 level, significantly below its 2008 peak. Helped by low interest rates, debt service relative to household income has fallen back to levels not seen since the early 1980’s. But consumption will be hit by the expiration of the payroll tax cut, which will reduce household income by about $125 billion this year.
Another factor holding back recovery has been weak growth in spending on goods and services by both state and local governments, and more recently by the federal government. Indeed, since the recession’s onset, state and local governments have cut nearly 600,000 jobs and reduced spending for infrastructure projects by 20%.
The fiscal trends for 2013 are mixed, but negative overall. While state and local government cutbacks in spending and employment are ending as the recovery boosts their tax revenues, the fiscal drag at the federal level is strengthening. The American Taxpayer Relief Act – the tax deal reached in early January to avoid the “fiscal cliff” – shaves about $750 billion from the deficit over the next ten years and could take a percentage point off the 2013 growth rate. In addition, although less widely appreciated, significant reductions in federal spending are already under way, with more likely to come.
Spending cuts and revenue increases that have been legislated since 2011 will reduce the projected deficit by $2.4 trillion over the next decade, with three-quarters coming from spending cuts, almost exclusively in non-defense discretionary programs. Based on current economic assumptions, the US needs about $4 trillion in savings to stabilize the debt/GDP ratio over the next decade. It is already three-fifths of the way there.
The so-called sequester (the across-the-board spending cuts scheduled to begin in March), would slash another $100 billion this year and $1.2 trillion over the next decade. Although it could stabilize the debt/GDP ratio, the sequester would be a mistake: it fails to distinguish among spending priorities, would undermine essential programs, and would mean another significant dent in growth this year.
Moreover, despite the warnings of deficit alarmists, the US does not face an imminent debt crisis. Currently, the federal debt held by the public is just over 70% of GDP, a level not seen since the early 1950’s. However, government debt soars by an average of 86% after severe financial crises, so the increase in the federal debt by 70% between 2008 and 2012 is not surprising.
Nor is it alarming. The US economy grew rapidly for several years after WWII with a higher debt/GDP ratio, and today’s ratio is lower than in all other major industrial countries (and roughly half that of Greece, analogies to which are absurd and misleading).
During the last two years, Washington has been obsessed with the need to cut the deficit and put the debt/GDP ratio on a “sustainable” path, even as global investors have flocked to US government debt, driving interest rates to historic lows. The considerable progress that has been made on deficit reduction over the next ten years has been overlooked. Also overlooked have been the immediate challenges of low growth, weak investment, and high unemployment.
It is time to refocus. The US needs a plan for faster growth, not more deficit reduction. Evsey Domar, a legendary growth economist (and one of my MIT professors) counseled that the problem of alleviating the debt burden is essentially a problem of achieving growth in national income. We should heed his wisdom.