The U.S. economy is in the longest and deepest recession and stagnation since the 1930s. The economy peaked in 2007, and the unemployment rate has barely been below 9 percent since then. The 8.5 percent rate reported in January is deceptive because at least 5 percent of the labor force has dropped out because they are unable to find work, and they are not counted in the unemployment rate.
Much of the recent decrease in the unemployment rate is the result of these dropouts, inevitable as the stagnation lengthens. Known as Okun’s Law, this phenomenon is part of typical recessions but is more severe than usual because of this stagnation’s length and severity.
Began Before Obama
This recession did not start with the Obama administration. Gross domestic product (GDP) peaked in real terms well before President Obama’s inauguration in early 2008. The recession started in the housing sector. The common characterization is of a speculative ‘housing bubble’.
This ignores the classical finance theory result that if speculators make abnormal profits, they stabilize relevant markets by buying when prices are low and selling when prices are high, thus adding to demand when prices are low and adding to supply when prices are high, moving prices toward equilibrium.
The housing development and construction sectors contain aggressive and competitive firms. A “bubble” would be short-lived if supply were unconstrained. But housing development and construction are increasingly constrained by local government controls on housing density and land use.
Pushed by Supply Constraints
In California metropolitan areas, and others where the housing supply is highly constrained, housing prices rose about 10 percent per year during the decade, ending in 2007. A family with conventionally measured annual income of $100,000 per year could rationally invest in a million-dollar home with as large a mortgage as it could obtain and make about $100,000 per year in meagerly taxed capital gains, thus doubling their income aside from deductible interest on the unusually large mortgage.
Such investments were rational, provided the family expected the trend to continue a few more years. People were encouraged by advertisements that “housing is your best investment.” Realtors and lenders were also encouraged by government urging the origination of subprime mortgages in underserved neighborhoods.
In this environment, defaults were rare, and not only lenders but also buyers of mortgages and mortgage-backed securities were induced to be highly leveraged. Despite excessive local government density controls, housing supply gradually expanded in response to high housing prices, in good part by building in distant and less regulated suburbs. During the resulting massive drop in housing prices, some lenders and buyers of real estate securities, including Fannie Mae, were threatened with bankruptcy and bailed out with taxpayer money.
As housing prices fell, the Obama administration panicked and bailed out not only homeowners whose homes were worth less than their mortgages but also financial firms that owned large amounts of real estate securities and which were judged too big to fail.
This cycle can legitimately be characterized as a speculative housing bubble, but it was caused by housing supply restrictions imposed by local governments.
Total Failure of Keynesian Moves
As has been amply demonstrated, the Obama administration responded to the recession in classical Keynesian fashion. Government spending has risen to $3.8 trillion, entailing an annual budget deficit of $1.5 trillion and total federal debt of $15.5 trillion, a bit larger than the nation’s gross domestic product. In 2010, U.S. government spending was the highest relative to GDP since 1945. The government forecast is of trillion dollar deficits for the foreseeable future.
The Federal Reserve has acted in similar Keynesian fashion by increasing the money supply by a third from 2007 to 2011.
The benefits of these massive expansions of federal spending and money stock have been approximately zip. Real GDP was barely 1 percent greater in 2011 than in 2007. The unemployment rate is double its 2007 rate, despite large withdrawals from the labor force by discouraged workers.
Debt Comes With Costs
The basic reason for the limit to the benefits of Keynesian deficit financing is a corollary of Milton Friedman’s famous theorem, “there is no free lunch.” Business debt financing is costly because the discounted cost of interest on the debt plus the discounted cost of paying the maturity value of the debt is the same as the value of the debt when it is issued. Businesses nevertheless issue debt because they expect the revenues from the resulting investment to exceed the cost of debt.
The same applies to government debt financing. Although governments rarely pay off the bonds they issue when they mature, they refinance with new bonds. But the same resu