Historically, all recoveries from recessions precipitated by a financial crisis have been long and slow. Our current recovery from the financial crisis of 2008 is starting to look longer and more uncertain than the historical norm. The main reason is the enormous uncertainty over future taxes, spending priorities, and regulations coming from the government. Our looming debt crisis requires significant adjustments in government policies one way or another (see my earlier note on “Thinking about the public debt”) and private investors and consumers naturally retreat in the face of such uncertainty until the course of government policies is settled.
Our high unemployment rate means that aggregate spending (demand) on U.S. output falls short of full employment output. At the highest level of aggregation, economists divide total aggregate demand into the spending by households on current goods and services (Consumption), spending by businesses on capital and capacity improvement (Investment), spending by foreigner (Exports), and spending by the government at all levels (Government).
The Federal Reserve quickly and correctly injected liquidity into the financial system in 2008 – 9, thus containing the scope of the financial crisis. There is nothing left for it to do other than withdraw the extra liquidity in time to avoid inflation when the right time comes.
The government increased its demand for output through several stimulus programs in an effort to fill the demand void created by the retrenchment of private sector Consumption and Investment. Government stimulus required spending without tax financing because tax increases would have further reduced private Consumption and Investment just as tax reductions were meant to increase them. The resulting deficit is unsustainable and has itself become a source of concern. Moreover, some of the government’s increased spending reflected long-term increases in the size of government rather than temporary countercyclical stimulus adding to long-term debt sustainability concerns as well as concerns about government encroachment into undesirable areas. Government stimulus is now being withdrawn.
Recovery requires an increase in Consumption, Investment, and Exports sufficient to match full employment output without the artificial boost of Government stimulus. So what is holding it back?
Until recently, the recovery, slow as it has been, was being lead by an increase in Exports. Over half of our exports go to Europe and recent debt problems in Europe (Greece, Ireland and Portugal) have slowed Europe’s economic recovery and its demand for American exports.
The main factor holding back the recovery of Investment and Consumption is the large uncertainty over the environment in which firms would invest and households would spend. Businesses invest when they think it will be profitable to do so. Significant changes and prospective changes to business and especially financial regulations will take several years to clarify. Until they do it will not be possible to estimate their cost on businesses (and thus consumers) with any accuracy.
Everyone has now accepted the fact that government spending levels and projected levels combined with existing tax revenue and projected revenues are not sustainable. Significant adjustments are unavoidable. The problem is that there is no consensus about what spending to cut and how much to cut it, and what taxes to change and by how much. This is particularly challenging for the big three categories that make up most of the budget (defense, Medicare/Medicaid, and social security). Businesses find it particularly difficult to estimate the tax treatment new investments might face and follow the sensible path of just waiting to see.
The impasse between Republicans and Democrats in the Congress over the conditions they each require to raise the debt ceiling is in the news and in our faces daily. Few firms are willing to undertake new investments in such an environment.
It is unthinkable that Congress will not raise the debt ceiling, but that does not mean that the game of chicken might not postpone raising it until considerable additional damage has been done to the economy. The stakes are high and neither side will yield easily. The government would quite properly cut expenditures or default on other obligations before they would default on its debt (the U.S. government securities held by households, banks and other firms, as well as other governments around the world). The unquestioned integrity and safety of U.S. government securities is one the critical backbones of the role of the dollar as an international reserve asset and of the dominance of the United States in world financial markets and commerce. But what would it cut?
The expected revenue shortfall for 2011 is $912 billion.[1]Failure to raise the debt ceiling would mean that planned spending would need to be cut by that amount if it could not be borrowed (or taxes increased—but increased revenue from higher tax rates or new taxes, if they materialized at all, would take some time to collect). If the cuts are made in areas other than interest on the existing debt (which for this year is expected to be $287 billion) they will have to include cuts to entitlements like social security and Medicare or defense because discretionary spending (the total Federal budget less defense, entitlements and interest on existing debt) is only $656 billion it cannot be cut below zero. The cuts would need to be greater than the entire defense Department budget of $727 billion. These would be actual cuts, not reductions from planned increases. It is hard to imagine the government defaulting on it monthly social security payments to pensioners or cutting off payments for covered medical treatments or defaulting on salary payments to government employees. Thus the debt ceiling will have to be raised in order to allow a longer more orderly adjustment to spending priorities and levels, which when agreed should be fully financed by an efficient and equitable tax system (see “US Federal Tax Policy”).
Our faltering economy is the result of the government’s inability to get its act together, agree on the rules and on the tax and regulatory environment in which households and businesses operate, consume and invest. No side can force a decision and have their way. It is not reasonable to expect a major reworking of entitlements or the tax system in the next two months, but it is possible to agree on the aggregate size of the cuts required for Republicans to agree to an increase in the debt ceiling so that entitlements, defense and taxes can be more carefully debated over the next year. House Speaker John Boehner’s offer to support a dollar increase in the debt ceiling for every dollar cut from the budget deserves support. But it will only buy badly needed time to more fundamentally reform entitlements, defense spending, and the tax system.
Until these decisions are made and the business environment clarifies and stabilizes, investment and economic recovery will suffer.
[1] Office of Management and Budget, “Budget of the United States Government”
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