How much is the United States growing today and how are we likely to grow in the future? And most importantly, how can economic policy support growth?
Edward Lazear, Chairman of the Board of Overseers for the Becker Friedman Institute, addressed these fundamental questions in a talk for University Chicago alumni and friends at the Gleacher Center March 5.
Lazear began by showing a graph of economic growth in the period since World War II. Growth averaged roughly 3 percent from 1947 through 2007. Growth was never perfectly steady, declining in recession and accelerating with an expansion, but overall it was surprisingly consistent and robust. After a recession, the economy tended to return to the historical growth trend line fairly quickly.
Figure 1–GDP Growth in the U.S., 1947–2012
The current recovery from Great Recession of 2008–2009 breaks that pattern. Growth has, so far, not moved back to the long-term trend, averaging only 2 percent . Last year was even worse at roughly 1.5 percent. We are seeing positive growth but have not regained lost ground or returned to normal growth.
Figure 2–The Current Recovery
This is unique in postwar recoveries. History shows that a severe recession is not always followed by an anemic recovery. In fact, the recovery from the Great Depression years 1929–1933 was astounding–almost 11 percent per year, interrupted by another downturn in 1937. This strong recovery was not, as many people assume, driven by a prewar economic boom, Lazear noted, occurring well before the US was drawn into the war.
Figure 3–Recoveries from Major Recessions
But the Great Recession was also by far the worst since the Great Depression. For the average of the 10 recessions from 1947 through mid–2000s, real GDP fell 1.7 percent; in the recent downturn it fell 4.7 percent
What was so different about the recession of 2007–2009? Lazear outlined one explanation, put forth by Carmen Reinhart and Kenneth Rogoff in their book This Time is Different: Eight Centuries of Financial Folly, is that the current recession follows a period of financial overindulgence. Reinhart and Rogoff show that across the centuries and around the globe, recessions following financial shocks tend to be deeper and longer than recessions caused by other factors. Likewise, recoveries after financial crises can be slow and protracted.
The worst recessions by far follow crises where the financial system has been destroyed, as in the early 1930s. By 1933, 11,000 of the nations 25,000 banks had disappeared; 9,000 of them had failed. In contrast, the recent financial crisis did not irreparably damage the financial system. Bear Stearns was sold (in distress) to J.P. Morgan, Lehman went into bankruptcy, AIG was effectively bought by the government, Fannie Mae and Freddie Mac were nationalized, but the financial system did not collapse.
Lazear, an acclaimed labor economist who served at chair of the President's Council of Economic Advisers from 2006 to 2009, said others have suggested that a structural change in the economy explains the current slow recovery. They argue that industries and companies seeking workers today are different than 10 years ago, so there is a structural mismatch between the skills required and the occupations of unemployed workers. Growth will be slow while the workforce responds to these changes and the mismatch between human capital supply and demand is corrected.
Lazear cited the housing sector as an example. When the housing bubble burst and construction jobs disappeared, the construction workers needed to move to new and growing sectors such as health care. But it takes time for a construction worker to re-train and find a job as a nurse.
If a structural change is to blame for the lagging growth, that calls for a different policy response than other causes might, Lazear noted. Monetary stimulus, even if it were normally effective in counteracting business cycle downturns, would not be effective in addressing structural labor market mismatches, and Federal Reserve policy makers need to know this.
Some simple observations hint that unemployment changes may not be structural. First, unemployment went from 4.4 percent in mid–2007 to 10 percent by late 2009; the structure of the economy generally does not change that fast. Second, unemployment by industry does not match what we might expect. While construction was hit by far the hardest, unemployment rose in other industries as well during the recession, and construction unemployment fell sharply after the recession ended, which would probably not happen if it were a structural shift.
Figure 4–Industry Unemployment Rates
More sophisticated measures of labor markets show that structural mismatch did increase sharply during the recession. Figure 5 shows that it fell again during this recovery and is now back down to 2006 levels we saw in 2006. Structural mismatch in the labor market does not appear to be the explanation for the continuing slow recovery, Lazear concluded. This removes one argument against applying monetary stimulus to tackle the slow recovery. (This might not be the conclusion a traditional Chicago-style economist might wish, but it is nonetheless what the data show, he added.)
Figure 5–Industrial Mismatch Over Time
Lazear showed figures from the recession suggesting that the U.S. is becoming more like Europe, both in terms of sustained high levels of unemployment since 2007 (Figure 6) and in terms of government debt and deficits. In Figure 7 we can see that the debt-to-GDP ratio for the US has climbed from below 40 percent– roughly our long-term average–to closer to 80 percent today. The increase is a result of both lower tax revenue as the economy declined and increased government spending in response.
Figure 6–Annual Unemployment Rates
Figure 7–Debt to GDP
The U.S. deficit-to-GDP ratio has soared, from below 4 percent before the recession to over 8 percent today–higher than Italy, Spain, and France. (Figure 8) Why is Italy under fiscal pressure with a deficit of 3 percent or less while the US, with a deficit closer to 9 percent, is not? Lazear explained that Italy's debt levels are so high that the interest rates they must pay to service and roll over their debt cause great fiscal stress. Without the debt service, Italy now actually runs a primary surplus, bringing in more that they spend. “That is where we in the US need to worry, if our debt rises too high and we no longer have the luxury of paying such low interest rates, then the debt may become unsustainable,” Lazear said.
Figure 8– Deficit to GDP
Figure 9 shows the story in stark terms–taxes and spending as percent of GDP, projected by the White House's Office of Management and Budget. Spending is projected to rise substantially, to 26 percent of GDP and higher. The ratio of taxes to GDP is now down to roughly 15 percent, well below the long-term average of 18 percent. Tax revenue is projected to rise to 20 percent of GDP, but even at that level the gap between revenue and spending means adding 7 percent of GDP per year to the debt. That is not sustainable , Lazear said.
Figure 9–Taxes and Spending
In the long run the US will have to either cut spending or raise taxes. Simply raising taxes on the rich will not generate the necessary revenue, he added. To boost revenues sufficiently to cover he gap, the only practical solution is a national Value Added Tax (VAT). Most developed countries have a VAT; the US is a major exception.
Lazear highlighted four additional policy prescriptions the US should be considering:
- Budget: reduce spending. Everyone agrees on this, but the US needs serious discussion, particularly on health care spending.
- Tax policy: most policy makers are at least willing to think about tax reform. Lazear served on President Bush's tax reform advisory panel in 2005, which advocated consumption taxes such as the VAT. Another possibly easier reform is to eliminate tax on investment.
- Trade: reduce trade barriers. Current administration proposals to negotiate a free trade agreement between the EU and NAFTA countries would be beneficial.
- Regulation: take a harder look at how we look at regulation. This is not to advocate dispensing with government regulation, but rather to regulate sensibly, to consider both the costs and the benefits of regulation.