Economic Outlook: Top Concern As We Wind Down 2009
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The principal threat to the economy as we move toward 2010 is the excessive burden that government expansion will place on the private sector. Moderating the size of government is essential to a well-functioning economy. Yet, the current Administration has made it clear that it has no intention of checking its spending. Quite to the contrary, everything that the Obama Administration has announced implies a major expansion of government to levels well above our historic norm.
There are four important points. First, the economy is recovering, but less negative numbers do not by themselves imply recovery. Second, while the stimulus probably has not done significant harm, it had little to do with the slower rate of decline that we experienced in the second quarter as compared with the first. Third, unfortunately, the labor market will take a significant period to recover, and there is little we can do to change that. And fourth, to repeat, the foremost threat we face is an excessive government burden that will stifle future economic growth.
The economy is recovering. While it is better to have smaller rates of decline than large ones, it is important to remember growth rates must become positive, not just less negative, in order to see a recovery. A slower decline in the labor market or in GDP simply means it takes us longer to get to Hell, but we still get there. In particular, the Administration celebrates that job losses are only a quarter of a million jobs per month rather than more than half a million and that initial unemployment claims are in the high 500,000 range rather than the high 600,000 range. However, as the economy reaches very low levels of employment it is natural that we shed jobs more slowly. Indeed, the first jobs to go are the easiest to cut, and since we are now at a low level of employment, cutting additional jobs becomes increasingly difficult. But, that does not mean that the labor market will turn around rapidly. The 9.8%* unemployment rate speaks for itself. (During the Bush term, it averaged 5.4% and during the Clinton term, it averaged a similar 5.3%.) Persistently high unemployment is an unfortunate characteristic of recessions and the one that is felt broadly, directly or indirectly, by most Americans.
Still, there are a number of positive signs. At the vanguard of these is that the housing market has shown some indication that it will stop being a drag on GDP. For the past couple of years, GDP has been pulled down by declines in housing construction spending. Just getting to zero will be a big plus. Second, manufacturing now looks more promising. There is some likelihood that industrial production will pick up significantly as firms rebuild their inventories during the fall. Third, and most important, the primary source of the problems that caused the recession was difficulty in the financial sector that occurred throughout 2007 and 2008, reaching a critical stage in September of 2008. The steps taken by the Bush Administration and by the Federal Reserve did much to bring the financial sector back into a reasonable shape. Indeed, by the end of 2008, the financial sector was well on its way to recovery, and today there seems to be little danger that the conditions we saw last September will be repeated. The best evidence that the financial sector is healing is that additional money for the TARP has not been required. In addition, many of the programs that the Obama Administration announced have yet to be implemented. In large part that was due to a difficulty in administration. But the failure of the Public and Private Investment Partnership (PPIP), which was the centerpiece of the Obama plan for getting the toxic assets out of the economy, is probably fortuitous. The PPIP would have done little to remedy the situation and, indeed, at this point it is unnecessary. The unwillingness of banks and other financial intermediaries to play ball with the Administration on the PPIP is no accident.
The stimulus that occurred during the second quarter of this year probably did bring a little additional growth to the economy. Still, it accounted for a very small portion of the difference between the -6.4% growth rate in the first quarter and the -1.0% growth rate in the second quarter. Using the same methods that we used when I was Chairman of the Council of Economic Advisors, I estimate that the stimulus, including tax cuts, account for less than one percentage point of the 5.4 percentage point difference between quarter one and quarter two. It is a fact that economies recover without government intervention, and the experience in this recession will be no different.
The labor market will be slow to recover, and, unfortunately, there is little the government can do to speed it up. Stimulus spending occurs too slowly and has only small and delayed effects on the labor market. Recoveries have a consistent pattern. First, GDP recovers and productivity grows. Firms increase their output not by hiring more workers, but instead by getting more output out of the workers that they have. With significant delay, as demand continues to increase, firms then hire additional workers and the unemployment rate falls. Finally, when unemployment reaches sufficiently low levels, say in the 5% range, we start to see upward pressure on wages. An examination of recessions dating back to the 1960s exhibits the same pattern throughout each recovery. We can expect that this one will be no different from the past, and that it will take a significant amount of time for the labor market to recover. The pain of this slow labor recovery will tempt the government to try to speed up the labor market’s resurgence. This temptation should be avoided as succumbing to it will be counterproductive.
The chief threat to future economic growth and stability is the vast expansion of government announced by the current Administration. A large part of this expansion has been camouflaged as stimulus. The additional spending of $787 billion, most of which will occur in 2010 and 2011, with the smallest amount occurring in the current year when the recession is at its height, represents permanent government expansion cloaked in the guise of temporary spending. Additionally, plans to change the health care system and other budget announcements by the Administration make clear that we are on target for a major change in the size of government relative to GDP. Using the Administration’s own projections, the 10-year deficit will be nine trillion dollars and will, in 2009 alone, be in the range of 10-11% of GDP, more than three times the highest deficit during the Bush years. A key number to consider is the ratio of public debt to GDP, which has averaged about 37% for the past forty years or so. When the Obama team came into office, it was at 40%, and by the end of this Administration’s first year in office it will reach 50%. If the Obama administration’s projections prove correct, the ratio of public debt to GDP will be 80% by 2019. Excessive government spending must be paid for. And it will be. Present borrowing will be paid for in the future either in the form of taxes, inflation, or further borrowing from abroad, which in turn means higher taxes or inflation.
All of these factors have pernicious, negative consequences for economic growth. A reduction in the long-term growth rate has large detrimental effects for our children. Indeed, if our equilibrium long-term growth rate fell from about 3% to 2.5%, the next generation’s wealth would be reduced by about 25%. For context, the current recession, as bad as it was, will reduce the wealth of the next generation by only about 5%, and perhaps significantly less if there is the typical bounce-back that occurs after most recessions.
The final point – that the growth of government almost certainly means a reduction of growth in the private sector – is one worth remembering.
Mr. Lazear is a professor at Stanford University's Graduate School of Business and a Hoover Institution fellow. He was chairman of the President's Council of Economic Advisers from 2006-09.
*This figure was updated after the new data release on October 2, 2009