The United States continues to recover from its deepesteconomic slump since the Great Depression, but the pace of recovery remainsfrustratingly slow. There are several reasons to anticipate modest improvementin 2013, although, as usual, there are downsiderisks.
Prolonged recession or a financial crisis in Europe andslower growth in emerging markets are the main external sources of potentialdanger. At home, political infighting underliesthe two greatest risks: failure to reach a deal to raise the debt ceiling andan additional round of fiscal contraction that stymieseconomic growth.
Since 2010, tepid averageannual GDP growth of 2.1% has meant weak job creation. In both this recoveryand the previous two, the rebound in employment growth has been weaker and later than the rebound in GDP growth. But the loss of jobsin the most recent recession was more than twice as large as in previousrecessions, so a slow recovery has meant a much higher unemployment rate for a much longer period.
Weak aggregate demand is the primary culprit for subdued GDPand employment growth. The 2008 recession was triggered by a financial crisis thaterupted after the collapse of a credit-fueled asset bubble decimated the housing market. Private-sector demandcontracts sharply and recovers only slowly after such crises. Theprivate-sector financial balance swung from adeficit of 3.7% of GDP in 2006, at the height of the boom,to a surplus of about 6.8% of GDP in 2010 and about 5% today. This representsthe sharpest contraction and weakest recovery in private-sector demand sincethe end of World War II.
Growth in two components of private demand, residential investment and consumption, which accountfor more than 75% of total spending in the US economy, has been especiallyslow. Both sources of demand are likely to strengthen in 2013.
Residential investment is still at an historic low as ashare of GDP as a result of overbuilding duringthe 2003-2008 housing boom and the tsunami of foreclosures that followed. But the headwinds in the housing market are dissipating. Home sales, prices, and construction allrose last year, while foreclosures declined. Residential investment should be asource of output and job growth this year.
Large losses in household wealth, deleveraging fromunsustainable debt, weak wage growth, and a decline in labor’s share ofnational income to a historic low have combined to constrain consumptiongrowth. Real median household income is stillnearly 7% below its 2007 peak, real median household net worth dropped by 35%between 2005 and 2010 (and remains significantly below its pre-recession peak),and about 90% of the income gains during the recovery have gone to the top 1%.
To be sure, the balance-sheet headwinds holding backconsumption have eased. Households have slashedtheir debt – often through painful foreclosures and bankruptcies – and theirdebt relative to income has sunk to its 2005 level, significantly below its2008 peak.  Helped by low interest rates, debt service relative tohousehold income has fallen back to levels not seen since the early 1980’s. Butconsumption will be hit by the expiration of thepayroll tax cut, which will reduce household income by about $125 billion thisyear.
Another factor holding back recovery has been weak growthin spending on goods and services by both state and local governments, and morerecently by the federal government. Indeed, since the recession’s onset, stateand local governments have cut nearly 600,000 jobs and reduced spending forinfrastructure projects by 20%.
The fiscal trends for 2013 are mixed, but negative overall.While state and local government cutbacks in spending and employment are endingas the recovery boosts their tax revenues, the fiscal drag at the federal levelis strengthening. The AmericanTaxpayer Relief Act – the tax deal reached in early January to avoid the“fiscal cliff” – shaves about $750 billion fromthe deficit over the next ten years and could take a percentage point off the2013 growth rate. In addition, although less widely appreciated, significantreductions in federal spending are already under way, with more likely to come.
Spending cuts and revenue increases that have beenlegislated since 2011 will reduce the projected deficit by $2.4 trillion overthe next decade, with three-quarters coming from spending cuts, almostexclusively in non-defense discretionary programs. Based on current economicassumptions, the US needs about $4 trillion in savings to stabilize thedebt/GDP ratio over the next decade. It is already three-fifths of the waythere.
The so-called sequester (theacross-the-board spending cuts scheduled to begin in March), would slashanother $100 billion this year and $1.2 trillion over the next decade. Althoughit could stabilize the debt/GDP ratio, the sequesterwould be a mistake: it fails to distinguish among spending priorities, wouldundermine essential programs, and would mean another significant dent in growth this year.
Moreover, despite the warnings of deficit alarmists, the USdoes not face an imminent debt crisis.Currently, the federal debt held by the public is just over 70% of GDP, a levelnot seen since the early 1950’s. However, government debt soars by an averageof 86% after severe financial crises, so the increase in the federaldebt by 70% between 2008 and 2012 is not surprising.
Nor is it alarming. The US economy grew rapidly for severalyears after WWII with a higher debt/GDP ratio, and today’s ratio is lower thanin all other major industrial countries (and roughly half that of Greece,analogies to which are absurd and misleading).
During the last two years, Washington has been obsessedwith the need to cut the deficit and put the debt/GDP ratio on a “sustainable”path, even as global investors have flocked to US government debt, drivinginterest rates to historic lows. The considerable progress that has been madeon deficit reduction over the next ten years has been overlooked. Alsooverlooked have been the immediate challenges of low growth, weak investment,and high unemployment.
It is time to refocus. The US needs a plan for fastergrowth, not more deficit reduction. Evsey Domar, a legendary growth economist(and one of my MIT professors) counseled thatthe problem of alleviating the debt burden is essentially a problem ofachieving growth in national income. We should heedhis wisdom.