Fiscal Challenges and Fiscal Follies

BERKELEY – Where is America’s economy headed in 2013? Will the recovery continue at its frustratingly slow pace? Or will it accelerate as the housing sector rebounds, bank lending expands, household balance sheets improve, and state and local government budgets strengthen?

With economic headwinds dissipating, the United States’ prospects for faster GDP growth appear promising. But there is also a significant risk that a large and unnecessary dose of fiscal austerity will weaken demand, undermine confidence, and tip the economy back into recession.

Since 2010, annual GDP growth has averaged about 2.1%, less than half the average of recoveries from previous US recessions over the last 60 years. Slow GDP growth has meant slow employment growth. The unemployment rate remains about two percentage points higher than what most economists consider consistent with a full recovery, and the labor-force participation rate is hovering near historic lows. The economy is still operating far below its potential: GDP is about 6% below what the economy is capable of producing at full capacity without higher inflation.

Tepid growth reflects weak demand. Housing prices are rising, and, while residential investment is increasing, it remains depressed as a share of GDP. Households have cut their debt and rebuilt their balance sheets, but the large loss in household wealth, weak growth in wages and income, the concentration of most income gains at the top, and a decline in labor’s share of national income to record lows continue to constrain consumption.