What Economic Recovery?
Due to bad government policies, we are not fully out of the recession yet.
Four years ago, the Business Cycle Dating Committee of the nonpartisan National Bureau of Economic Research concluded that the U.S. recession of 2007-2009 ended. Nearly all recoveries following severe U.S. recessions have featured robust economic recoveries that rapidly restored real income, output, and employment to their pre-recession trends. But this recovery has not.
Income, production, and jobs have not only failed to recover, but have continued to deteriorate. In the last four years, the fraction of the adult working age population (16 years old and over) has declined from 59.4 percent in June 2009 to 58.6 percent in May 2013, and per-capita inflation-adjusted gross domestic product is now 12 percent below its pre-recession trend compared to about 9 percent below trend at the recession trough of June, 2009. These statistics represent one of the weakest economic recoveries on record. Since late 2007, the U.S. economy has lost about 4 years of growth and is more than 10 million jobs below normal.
Markets Were Recovering
So why is the current recovery so weak? It is not because of the aftermath of the 2007-08 financial crisis. U.S. Financial markets began to recover in late 2008, more than four and a half years ago. Moreover, research by Michael Bordo of Rutgers University and Joseph Haubrich of the Federal Reserve Bank of Cleveland show that US recoveries following financial crises are typically faster, not slower, than average.
Recent research by us and other scholars analyzes the chronically slow economic recovery from a very different perspective. Specifically, our view is that poorly designed and implemented government policies have impeded capital and technological investments and hiring, and that bad government policies – not underlying problems with the U.S. market economy – are the primary reason why the economy has not recovered.
Since the fall of 2008, the U.S. government has adopted dozens of policies that were advertised as being necessary to restore prosperity. These policies impacted many key economic channels, including monetary and fiscal policies, commercial and investment banking, manufacturing, housing, and the environment.
Officials Made Bad Diagnoses
But many of these policies have depressed growth by distorting the normal forces of supply and demand that are critical for a market economy to function well and create new jobs. Many of the policies that were implemented were based on old Keynesian models that advocate temporary spending increases and one-time tax rebates, while others created new regulations of economic activity in key sectors. But both of these policy responses misdiagnosed the problems facing the American economy. The spending policies had little impact on the economy other than to increase government debt, and regulatory policies raised business costs and depressed growth.
The centerpiece of the old Keynesian stimulus policies was the 2009 $821 billion American Recovery and Reinvestment Act (ARRA), which combined temporary tax cuts with federal funds for national, state, and local government spending. President Obama's economic advisors stated that the ARRA would keep unemployment from rising above 7.9 percent, and would restore employment to its pre-recession trend around 2013. But the U.S. labor market remains severely depressed today, and is nowhere near its pre-recession trend.
Broad Response Begets Broad Failure
There are two important reasons why the ARRA failed to restore jobs. One is that attempts to stimulate spending likely had a much smaller impact than was advertised. The second is that the type of spending that was supposed to be undertaken – including investment in government infrastructure – simply did not materialize in any significant way. State and local governments did not use these federal funds to significantly expand infrastructure spending. Instead, these governments increased transfer payments and reduced debt, and the nation’s employment rate continued to decline.
Other spending policies were aimed at propping up the hard-hit auto and residential construction industries. These policies included “Cash for Clunkers”, which provided some new car buyers with payments between $3,500 and $4,500 by turning in an old car that was scrapped, and the Homebuyer Tax Credit, which provided some buyers of houses a tax credit of $7,500. These policies did little to strengthen either industry. Sales of autos and homes temporarily increased while these policies were in place, but then sales declined sharply once the policies ended. These policies were pure subsidies to some auto and home buyers, with little if any impact on the industries that were supposed to be helped.
Other policies imposed new regulations on key sectors of the economy, including the Dodd-Frank financial regulation legislation that regulates many aspects of banking and financial intermediation. Dodd-Frank was intended to solve the nation’s “too big to fail” problem, in which very large and complex banks would be bailed out should they face insolvency. But Dodd-Frank codifes the too big to fail problem. It allows regulators to identify banks deemed to be too big to fail, thus giving them certain advantages over small banks, and at the same time the legislation substantially raises the costs of doing business, particularly to smaller banks and particularly in the area of making home mortgage loans.
Uncertainty Adds to Problems
And it is not only the policies that have been implemented that harmed the U.S. economy. In some cases, uncertainty about economic policy has also depressed growth. Specifically, there has been considerable uncertainty about tax rates, with key tax provisions expiring each of the last several years and with little clarity on how tax rates would change over the long haul.
Between 2009 and 2011, roughly 250 tax provisions expired, about 10 times the number of provisions that expired in 1999. These expiring provisions make the tax system highly unpredictable, which in turn depresses the incentive for business to make long-term investments in capacity and technology, and holds business back from significantly expanding their workforce.
Tax Code, Other Reforms Needed
The U.S. has made some useful policy changes in the last few months. Government spending is no longer growing at the rate of previous years, and in fact, the sequestration budget cuts that were automatically imposed at the start of 2013 because the President and Congress were unable to agree on a budget appear to have had no negative impact on the economy, as old Keynesian models had wrongly predicted.
Getting the U.S. economy back on track requires restoring transparency and simplicity to the tax code, including reducing the U.S. corporate income tax rate, and reducing marginal income tax rates, which now exceed 50 percent in some states. In addition, growth will be enhanced by labor, energy, and environmental policy changes that make it less costly to hire workers and reduce the cost of becoming energy independent. When these changes are made, the U.S. economy will recover strongly. But without these changes, the U.S. economy will continue to significantly underperform, just as it has for the last four years.
Lee E. Ohanian (firstname.lastname@example.org) is a senior fellow at the Hoover Institution and a professor of economics and director of the Ettinger Family Program in Macroeconomic Research at the University of California, Los Angeles. John B. Taylor (JohnBTaylor@Stanford.edu) is the George P. Shultz Senior Fellow in Economics at the Hoover Institution and the Mary and Robert Raymond Professor of Economics at Stanford University. Reprinted with permission of Defining Ideas, a journal of the Hoover Institution at Stanford University.