The Magic of the Market
Why Has America’s Economic Recovery Stalled?
Martin Feldstein
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CAMBRIDGE – The United States’ import bill now exceeds $2.4 trillion a year, more than twice that of China and greater than that of the 27 European Union countries combined. Since the volume of US imports varies with the overall strength of the American economy, so does the volume of other countries’ exports.
So it was good news for everyone when the US economy began expanding in the summer of 2009, 19 months after falling into the recession that officially started in December 2007. Unfortunately, the recovery has turned out to be very anemic. Now, 15 months into the expansion, the level of real GDP is still lower than it was when the recession started.
Even more worrying, the rate of GDP growth has been declining almost from the start of the recovery. Real GDP rose by 5% in the fourth quarter of 2009, reflecting the end of the decline in inventories. GDP growth then fell to 3.7% in the first quarter of 2010 and to only 1.7% in the second quarter. The third quarter is shaping up to be much like the second.
This recovery has been much weaker than previous ones because of fundamental differences in the cause of the downturn and in the policies chosen to achieve recovery. Previous downturns were caused by the central bank’s efforts to reverse or prevent inflation by hiking short-term interest rates. When the central bank succeeded, it lowered those rates and the economy bounced back.
But this time the downturn was not caused by higher interest rates, and reducing those rates did not produce a strong rebound. This recession was caused by a mispricing of risk, leading to excessive leverage and high prices for a wide range of assets. When those price bubbles burst, households lost substantial wealth and financial markets became dysfunctional.
Because the downturn was not caused by high interest rates, lowering them could not lift the economy out of recession. The Obama administration therefore turned to fiscal policy – tax cuts and a range of spending programs. Unfortunately, the fiscal stimulus was not well enough designed to get the economy onto a strong, self-sustaining growth path. And, now that those stimulus programs are coming to an end, there is a danger that the economy will slide back into slow growth or even recession.
One key to the US economy’s future is household demand. Although consumer spending has increased during the past four quarters, helped by substantial government transfer payments, the pace of spending growth by households was less than the overall pace of GDP growth, because households were increasing their rate of saving. Indeed, household saving rose from 2% of after-tax incomes in 2007 to about 6% in recent months.
If the saving rate continues to rise at the same pace in the future as it has over the past three years, the overall GDP growth rate could turn negative after a few quarters. Of course, there is no way to be certain of what will happen to saving. But it is worth remembering that the saving rate averaged 9% in the quarter-century from 1960 to 1985. If the saving rate now rises quickly to that level, it will be hard to keep overall GDP growing. A significantly higher saving rate would help the US economy in the long run, but it would be a barrier to robust growth in the next few years.
A major obstacle to higher consumer spending is the current condition of the housing market. The rapid rise in house prices until 2006 caused households to increase their spending, financed in part by converting home equity into cash. But house prices have since fallen some 40% on average, leaving one-third of homeowners with mortgages owing more than their house is worth.
The resulting fall in wealth has reduced consumer spending, while the decline in homeowners’ equity prevents borrowing to finance any increase. And the recent end of a special tax subsidy for first-time homebuyers has caused house prices to start falling again. If that decline continues, it will inevitably reduce the pace of consumer spending.
Earlier this year, economic forecasters were predicting that annual GDP growth would reach 3% or more in the second half of 2010. Now those projections have been cut to less than 2%, which is too slow to make a dent in the very high rate of unemployment. The forecasters have now shifted their predictions of 3%-plus growth to 2011. Let’s hope that they are right this time.
Martin Feldstein, Professor of Economics at Harvard, was Chairman of President Ronald Reagan's Council of Economic Advisors, and is former President of the National Bureau for Economic Research.
Copyright: Project Syndicate, 2010.
www.project-syndicate.org
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dannyb2b 02:27 27 Oct 10
In order to expand GDP and savings at the same time all that is needed is to modify how the FRB operates monetary policy.
First the FRB needs to stop dealing with a few major banks and deal directly with the public in order to circumvent the liquidity trap. In this arrangemnet all citizens have an account with the FRB and in order to stimulate the economy the FRB expands the money supply and transfers these new funds equally accross the population. This would result in higher consumption and higher savings at the same time. Btw new funds created are not debt so the public would not have to pay these funds back.
bdesilets 02:34 29 Oct 10
Is increasing savings such a bad thing? I think we should focus on encouraging this trend and related increases in investment instead of trying to crank up the consumption machine again - the one that got us into this mess to begin with. I'm not sure how they calculate savings but I imagine that if you include paying down existing debt then the percentage is much higher. Credit card balances for one have been falling and I think this is also a good sign.
@ dannyb2b - distributing income directly to the people is what our unemployment benefits system does. These people are now paid to sit on their couches and they are not the best decision-makers regarding directing savings or newly printed money into productive investments. I believe ending unemployment benefits would drive more people back to work, thereby stimulating GDP.
dannyb2b 02:50 30 Oct 10
@bdesilets
Expanding aggregate demand directly through the public instead of through lending by commercial banks is a measure only to be utilised in times of inadequate demand while the structural imbalances are addressed.
If you expand the money supply through new debts as a result of lower rates or through money transfers the effect is the same. Peoples incentives wont be affected if for the next 6 months every citizen received 100USD a week into their FRB account. Thats not even enough to pay rent logically you aint gonna stop working if you obtain a small amount of money on a temporary basis. The positive though is that all those new funds avoid the liquidity trap and people use them to finance consumption, pay debts which heals the banking system or just save which provides the banking system with funds to lend for investment.All that neww demand would necesitate more production more employment and investment also.
Simply stopping UE benefits isnt a very good idea because there isnt jobs out there for those people to get because there isnt the demand for production and hence labour in the first place.
lukehlee 06:00 26 Oct 10
It looks as if we are in a serious dilemma, and we have no solution to avoid the upcoming deeper recession. I believe we need an Alexandrian Solution this time. Andreas Kluth said that the true “Alexandrian Solution” was, for example, what Albert Einstein was looking for in his search for a Grand Unified Theory — a formula that was simple enough (!) to explain all of physics. I believe there is also a solution that is simple enough (!) to effectively solve major problems (e.g.: unemployment and lack of consumption) of the current economic crisis. Suggest to see: A New System for the Real Market as a Solution for... http://t.co/MRirNf3