When fiscal policy lags, the one-two fiscal/monetary punch doesn’t land

August 15th, 2016 at 2:12 pm

Two recent pieces looked at where we are in this recovery and why, seven years into an expansion, we’re still not at full employment. One is by my main man Josh Bivens from the Economic Policy Institute and the other is by David Mericle and Avisha Thakkar from Goldman Sachs (GS) research (sorry; no link to that one).

The figure below–not from either of these pieces–motivates the discussion. It shows three lines of real GDP: an estimate of potential GDP pre-great-recession (2007), the most recent estimate of the same, and actual real GDP (potential GDP is CBO’s estimate of what GDP would be with fully utilized resources; it’s the value of the economy when it’s firing on all cylinders). I–somewhat artfully, you’ll surely admit–call this figure: The runner who can’t cross a goal line that’s moving towards her.

Sources: BEA, CBO

Sources: BEA, CBO

Why is that?

The GS folks take a unique and informative approach: they compare a spate of economic indicators in the US to the “Big Five” advanced economy financial crises (taken from the work of Carmen Reinhart and Kenneth Rogoff) as well as to the 2008 European crisis economies. Basically, GS asks: how has the US recovery gone compared to prior recoveries elsewhere from financial-crisis-induced recessions? (The “Big Five” include Spain in 1978, Norway in 1987, Finland in 1990, Sweden in 1990, and Japan in 1992.)

Josh provides a different but also useful comparison: prior US downturns.

The GS team concludes that the labor market in particular has outperformed their historical comparison groups, as shown through the unemployment rate comparison below. True, our unemployment rate is biased down due to the weak performance of labor force participation and still-elevated underemployment, but as I’ve extensively documented, the US job market has been tightening up for awhile, driven by solid employment growth, now averaging around 200,000/month. See Bivens’ Figure A on this point.

Source: GS Research

Source: GS Research

Still, as the first figure shows, the output gap is yet to close, even as potential GDP’s been downgraded. That reflects both slower labor force growth (some of which is demographics but some of which is weak labor demand) and our most serious outstanding economic problem, very slow productivity growth.

What’s most interesting to me about both the Bivens and GS studies is in regard to policy responses. Initially, US policy makers hit back hard with both monetary and fiscal policy. I’ve argued that the combination is important and complementary: monetary policy lowers the cost of borrowing but if households are both deleveraging and, based on the loss of housing wealth, suffering from lower net worth (i.e., a negative wealth effect), they’re less likely to take advantage of those lower rates. That’s when you need fiscal policy to put more money in people’s pockets such that they’ll tap the monetary stimulus. Ergo, the one/two punch.

Both studies show the following: the one/two punch of monetary/fiscal policy weakened when fiscal support for the recovery faded. The GS figure is striking (sticking with my artful theme, let’s call it Paul Krugman’s nightmare). Fiscal support started strong both here and in Europe, as did (see second figure) monetary policy (the negative numbers reflect the Fed’s lowering and holding down the Fed funds rate). But while the monetary authorities kept their stimulus going, austere fiscal policy kicked in with a vengeance.

Source: GS

Source: GS

Source: GS

Source: GS

Bivens austerity figure is also illuminating, and includes all three levels of government spending (fed, state, local).

Source: Bivens

Source: Bivens

Over to Josh:

[The above figure] shows the growth in per capita spending by federal, state, and local governments following the troughs of the four recessions. Astoundingly, per capita government spending in the first quarter of 2016—27 quarters into the recovery—was nearly 3.5 percent lower than it was at the trough of the Great Recession. By contrast, 27 quarters into the early 1990s recovery, per capita government spending was 3 percent higher than at the trough, 23 quarters following the early 2000s recession (a shorter recovery) it was 10 percent higher, and 27 quarters into the early 1980s recovery it was 17 percent higher.

His judgment is harsh and unequivocal…practically Old Testament:

If government spending following the Great Recession’s end tracked spending that followed the recession of the early 1980s for the first 27 quarters, governments in 2015 would have been spending an additional trillion dollars in that year alone, translating into several years of full employment even had the Federal Reserve raised interest rates. In short, the failure to respond to the Great Recession the way we responded to the other postwar recession of similar magnitude entirely explains why the U.S. economy is not fully recovered seven years after the Great Recession ended.

I think that’s probably right and I also think it helps to at least partially explain what may be the most negative development in any of the above pictures. I’m gonna let you guess what that is…I’m waiting…hint: it’s in the first figure.

It’s the sharp decline, from the 2007 to the 2016 vintage, in CBO’s estimate of potential real GDP. Hard to believe that downshift is a demographics story, because CBO estimators knew the population’s demographics back in 2007, when they had potential growing a lot more quickly. In fact, CBO assigns most of the reduced potential to “reassessed trends:” a more pessimistic outlook re hours worked and productivity than what they believed before the crisis. By taking half the punch out of the one/two fiscal/monetary punch, dysfunctional and mindlessly austere policy makers have contributed to the loss of hundreds of billions in value-added.

Still, sticking with the first figure, soon the aging runner will likely finally cross the goal line, and we’re doing better here than most other advanced economies. We’re nudging towards full employment and I’m even finally seeing a little pressure on wages. But it would be foolish to ignore the mistakes we’ve made and what they’re actively costing us in lost output, jobs, and living standards.

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4 comments in reply to "When fiscal policy lags, the one-two fiscal/monetary punch doesn’t land"

  1. Bob says:

    Fiscal policy after the crisis amounts to ‘fiscal malpractice’. What is particularly disturbing is that the the elite has profited mightily from it while the rest of us suffered. That reinforces the elite view that austerity (for the masses) is an evergreen policy response to everything. They have learned the wrong lesson.


  2. Nick Estes says:

    If you read the various economic histories of the recession, you will see how much fear of rising public debt freaked out the policy-makers–particularly in 2010 when everyone really turned to austerity, Greece had just happened, and all the pundits were telling the public that if we didn’t watch out, we’d all turn into Greece. In particular, the bond markets would start charging exorbitant interest, or stop lending altogether, plunging the industrialized world into financial chaos. You can also take a look at any CBO report, and you will read the same warning. Or Simpson-Bowles, of course.

    We never should have been borrowing this money and running up such large national debts. We cognicenti know that national debts are not of any great economic consequence, but it’s impossible to defend that position in public debate.

    Instead, we should have been financing our budget deficits by having our central banks (or the ECB) simply create the money and credit it to the various governments’ spending accounts–that is, by using helicopter money.. Achieving fiscal stimulus does not require increasing national debts and getting everyone so exercised about them. The entire world has suffered greatly because of the inability of policy-makers to think outside the debt box.

    You may dismiss this as politically unthinkable, but when the next recession comes, we will start with much higher debt levels than we had in 2008. If we don’t start educating policy-makers and the public about the possibility of providing fiscal stimulus without increasing national debts, we may get even less fiscal stimulus than we got the last time.


    • Smith says:

      Zero number of people running for office in 2010, 2012, and 2014 campaigned on raising the national debt to supply more fiscal stimulus. One can argue over whether the Republicans cynically knew all the talk of a debt crisis was a sham to deny Democrats a similar achievement to the recovery from the Great Depression. But top to bottom, Obama to congressman, all talk was of a grand bargain to cut the deficit, and were left playing defense. Even Krugman spent years just arguing against austerity because it was impolitic to attack his own party for timidity, ignorance, and corruption. To this day he agonizes over the failure of economics, economists, and the Democratic party of FDR to come to terms with a classic response to recession, Keynesian government spending. Only Bernie Sanders argued for full throttled expansion, and was pilloried for it in the press. Krugman has previously pointed out on occasion total government spending is far below what it should be, and a drag on the economy. But if were thinking about what went wrong start with the Summers’ memo of December 2008 which Krugman called in his blog evidence of inner circle confidence fairy beliefs right from the start.


  3. Smith says:

    Regarding pressure on wages, I don’t see it since as previously cited with supporting links, real wages are up 1.5% only because oil prices fell thus cutting overall inflation rate an additional 1%. Core inflation remains a steady bit less than 2%, and wages were thus climbing only .5% on their own power of traditional wage pressure. Oil prices are sure to recover somewhat at some point despite fracking. That will have a double effect of cutting wages and raising unwarranted inflation fears. Four years ago labor force participation still a full percentage point higher, representing 2.5 million more workers. Only half the loss can be attributed to demographics (aging workforce). Where’d the other 1.25 million go since 2012? New jobs need to continue to average 200,000 a month for another year to lure them back, and nominal wages must actually increase over and above 2% to get back to 2012 and all the way until 2020 to approach levels of 2008, and again that’s allowing for half of the lower participation for retiring boomers. Then you can talk about full employment.


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