From the performance of the US economy to the unprecedented policy mix being employed to address the current malaise, the United States is in uncharted economic waters. The US economy’s performance over the past 18 months has been unprecedented. There has never been a time when growth has been so anemic for so long. There have been 14 instances since the end of the Second World War when real economic growth fell to less than 2 percent. In 11 of those cases, a recession followed within two quarters of hitting the 2 percent stall level. In three cases, expansion reaccelerated. This is the first case where growth has neither accelerated nor fallen into recession.
What is also unprecedented about the weakness of the current recovery is that it is following a deep recession. Historically, deep recessions create pent-up demand. During a recession, businesses put off investments, and inventories are drawn down. Consumers put off purchases of cars and homes. Young people stay at home with their parents, putting off marriages and delaying the process of household formation to save money. When a recovery comes, much of this pent-up demand gets released, producing a strong recovery. In the three years following the end of the Great Depression in 1933, real GDP rose a sizzling 38.9 percent. That has not been the case this time; growth is up a modest 5.8 percent in the two and a half years since the end of the recession, which is the slowest pace of growth for any recovery since 1948 (see figure 1).
The performance of the labor force has also been uncharacteristic. Throughout the past 50 years, labor force participation has risen as women and baby boomers moved into the work force. With the baby boomers approaching their retirement years, one would expect labor force participation to begin to fall.
However, the mix of the decline in overall labor force participation does not fit the narrative of retiring baby boomers. Over the past five years, even as participation rates for other age cohorts have fallen, boomers have lingered in the labor force. Since the beginning of the last recession in December 2007, labor force participation among the 55–64-year-old cohort has actually risen slightly from 69.2 to 69.6 (see figure 2).
Over the same period of time, participation among 16–24-year-olds has plummeted from 61 to 55.6. Of the 4.3 million jobs created since 2010, nearly 3 million of them went to workers over the age of 55. The inability of young people to gain a footing in the labor market will stunt their career development and earning power for years to come. It will also make it more difficult for them to service their student loans. The default rate for the first three years on student loans has jumped $120 billion or roughly 13.4 percent of all outstanding student debt.
A falling standard of living
Weakness in the labor market has translated into an unprecedented decline in the standard of living (see figure 3). Real per capita income has dropped over a five-year period for the first time in the post-World War II era not once but twice in the past five years. Slow job growth coupled with declining labor market participation has made for a toxic combination for income growth. In addition, record low interest rates have cut deeply into interest income, sending it down from $1.4 trillion in May 2008 to $986 billion in August 2012.
In addition to the decline in per capita income, the household sector has also experienced an unprecedented decline in net worth. After peaking at $67.3 trillion in the third quarter of 2007, household net worth fell to $51.2 trillion in the first quarter of 2009, a stunning $16.1 trillion destruction of wealth. Since then, wealth has climbed due entirely to the rise in the value of financial assets. Even with the rebound, net worth is still down $4.7 trillion from its peak, and it actually fell by $300 million in the second quarter of this year.
The Fed’s response
Faced with a weak labor market and a declining standard of living, the Federal Reserve’s response to the current business conditions has also been unprecedented. Founded in 1913, it took the Federal Reserve 95 years to grow its balance sheet to just under $1 trillion. In the fall of 2008, in response to the collapse of Lehman Brothers, the Fed pursued its first round of quantitative easing (QE), purchasing a wide variety of financial assets in the process of doubling its balance sheet to just over $2 trillion (see figure 4). The purpose of the first round of QE was to provide liquidity to the banking system that was reeling from the shock of the Lehman bankruptcy.
In the fall of 2012, the Fed initiated a second round of quantitative easing, adding another $1 trillion to its balance sheet through the purchase of mortgage backed securities and US Treasury bonds. While the banking system no longer needed liquidity, the Fed’s objective was to lift asset prices in an attempt to encourage investment from banks and businesses and spending from consumers.
Two years later, with unemployment still above 8 percent and the economy still growing at a subpar rate of growth, the Fed has initiated a third round of quantitative easing. Unlike the previous efforts at QE, this one has no end date and no set amount. The Fed will buy $40 billion in Treasuries and mortgage-backed securities every month until unemployment falls below a level that is deemed acceptable by the Fed. Most Fed watchers expect QE3 to go on through 2013 at the very least, resulting in a $600 billion expansion of the Fed’s balance sheet at the very least.
Quantitative easing is not a risk-free policy. Printing money for the purpose of buying government debt risks higher inflation and a weaker dollar. While a weaker dollar would give a boost to exporters, it will result in higher import prices, particularly for energy.
The case for quantitative easing is that by suppressing interest rates, the Federal Reserve will force investors to take more risk in both the bond market and the stock market. The reduction in interest rates and the increase in investor risk taking will give a boost to asset prices in the housing market, the stock market, and the bond market. The corresponding rise in wealth from these three developments will bring about a recovery in the housing market and induce consumers to spend more and businesses to invest more.
The downside argument against more quantitative easing is that it results in a mispricing of risk. It reduces the income of retirees who depend on low-risk, interest-bearing assets. It also gives a boost to the price of food and energy, reducing the purchasing power of all consumers.
The fiscal cliff
The debate in the United States over fiscal policy revolves around the pending fiscal cliff (see figure 5). What is remarkable about this debate is how unremarkable it really is. Over the past decade, more and more of the tax code has become a part of a year-end dance between political parties, making longer-term tax and investment planning for businesses and individuals more challenging. In most years, indexing of the automatic minimum tax and various investment and R&D tax credits were among these items. Medicare’s “Doc fix” also seemed to require a yearly vote.
Three factors make this year’s fiscal cliff debate different: one is size, the second is timing, and the final issue is the reaction of the bond rating agencies.
Taken together, the tax increases and spending cuts that make up this year’s fiscal cliff come to roughly $600 billion. While there is no guarantee, there does seem to be some agreement on at least some of the elements of the fiscal cliff. Both sides are on record as favoring a phase out of the payroll tax cuts. The 2 percent payroll tax holiday that went into effect in 2010 represents roughly $95 billion in additional taxes. The automatic minimum tax gets bigger every year. The fix for the automatic minimum tax plus the “Doc fix” for Medicare are also likely to gain bipartisan support as they have in the past.
If the fiscal cliff isn’t addressed, as I’ve said, I don’t think our tools are strong enough to offset the effects of a major fiscal shock, so we’d have to think about what to do in that contingency.
—Ben S. Bernanke, Federal Reserve chairman
The big sticking point will be extending the Bush tax cuts for high-earning households. This was the point of contention back in August 2011 that led to the downgrade of US debt by the credit rating agencies. A second impasse over this issue could result in another downgrade. While the outcome of the fiscal cliff debate remains uncertain, at the very least, it seems certain that the United States will face much tighter fiscal policy in 2013 than it has in recent years. With an economy growing near 2 percent, tighter fiscal policy will slow growth in the short term. A failure to resolve any of the issues of the fiscal cliff could result in a significant increase in the fiscal contraction and a sharp recession in early 2013.
Conclusions and observations
The US economy has shown a combination of luck and resilience in avoiding a recession while growing well below its potential for the past 18 months. That resilience and luck are going to be tested in 2013 as the economy sails off into uncharted waters. Current monetary policy risks higher inflation and lower incomes for retirees and lower spending power for everyone else. The fiscal cliff impasse all but guarantees a more restrictive fiscal policy and potentially another credit downgrade. Sluggish employment growth, declining labor force participation, and shrinking real incomes are a dangerous combination that could push the economy into recession in 2013.