The slow U.S. recovery is vexing quite a few people. The recovery is compared with previous ones and found wanting by many observers.
The obvious explanation is the crisis in the eurozone. Virtually all of U.S. big corporations have a presence in Europe, it's still the U.S.'s most important export market, and the uncertainty is weighing on investment decisions. The case for blaming Europe is not particularly convincing, however. The U.S. isn't a very open economy and exports to the EU amount to only a few percentage points of GDP.
And while exports to Europe are suffering, exports to the rest of the world have made up for that. Of course the picture would be better still if Europe didn't have the problems it has, but to blame the tame recovery on Europe goes way too far.
However, should Europe deteriorate, especially if there is some sort of financial crisis, than things could be quite different.
Analysis by Credit Suisse estimates that up to 58% of the value of European banks could be wiped out by the departure of the 'peripheral' countries [Jill Treanor]
Well, that's European banks. But that will have a notable effect on the U.S. financial system as well.
Even if the single currency remains intact some €1.3tn of credit could be sucked out of the system as banks retrench to their home markets, unwinding years of financial integration, the Credit Suisse analysis warns. his represents as much as 10% of the credit in the financial system. [Jill Treanor]
That is likely to significantly deteriorate the recession in Europe and the worse it gets there, the bigger the effects in the U.S., especially if there is some kind of financial crisis.
Not a normal recession
The usual 'garden variety' business cycle at one stage or another leads to an overheated economy, low unemployment, little spare capacity and prices creeping up. Usually, the Fed slams on the brakes to cool the economy off by hiking interest rates, creating a deliberate recession in the process (which can be considered temporary collateral damage).
When inflation subsides, the Fed can lower interest rates, and the economy recovers. The higher the interest rates were, the more they can fall, and the more 'V shaped' the recovery can be. What happened in the aftermath of the steep rate hikes in the early 1980s is as good an example as any.
But this is no ordinary recession, it's a recession after a credit-infused asset bubble burst, leaving balance sheets of banks and households impaired (hence the term 'balance sheet recession,' by Richard Koo of Nomura). Households are still paying off debt:
household debt has now fallen to 84% of GDP from a peak of 98%. Nonfinancial corporate debt has fallen to 77% from a peak of 83%. Financial sector debt has plunged from 123% of GDP to 89%. Public debt has risen to 89% from 56%. [Yahoo]
It is this so-called 'deleveraging' - paying down debt in order to repair balance sheets, that makes the recovery especially slow. This process simply takes time. It's no wonder the recovery is tepid when:
A new survey by the Federal Reserve shows a shocking decline in the average net worth of U.S. households from 2007 to 2010. According to the report, which adjusted figures for inflation, the average American family saw their net worth drop 40% in that three-year time period from $126,400 to $77,300.
But what is surprising is the fact that overall net worth has fallen to levels not seen since the early 1990's, long before the housing bubble even began.[Yahoo]
- 1989: $79,600
- 1992: $75,400
- 1995: $81,200
- 1998: $95,500
- 2001: $106,100
- 2004: $107,200
- 2007: $126,400
- 2010: $77,300
Well, interest rates are already at zero, or at least the interest rates under direct control of the Fed. There isn't a whole lot more they can do. Unlike your garden variety business cycle recession where interest rates are the preferred, perhaps even the only tool of policy, these become rather powerless in a balance sheet recession.
The economy is in a so-called 'liquidity trap' in which there is simply no positive interest rates that can equate desired savings and investments.
If you look at the deleveraging process in the private (and financial) sector, you will realize private sector spending is reduced as a consequence. Add to that the crash in the economy as a result of the financial crisis and high unemployment, and there is even more spending reduction. When the private sector saves to pay off debt, somebody has to take up the slack to prevent this from turning into a 1930s style debt-deflationary spiral.
Well, there was the stimulus in 2009. It was designed for a situation where experts (The Bureau of Economic Analysis) expected the economy to shrink by 3.8% (annual rate). However:
Months later, the bureau almost doubled that estimate, saying the number was 6.2 percent. Then it was revised to 6.3 percent. But it wasn't until this year that the actual number was revealed: 8.9 percent. That makes it one of the worst quarters in American history. Bernstein and Romer knew in 2008 that the economy had sustained a tough blow; t hey didn't know that it had been run over by a truck. [Washington Post]
So the stimulus was designed for a much smaller shock than the economy experienced in reality, and it has already worn out. And in fact, to some degree public spending has gone into reverse.
(click charts to enlarge)
(the little bump in the 16th month of the Obama administration is related to temporary hiring for the census)
Taxes too high?
Much of the stimulus consisted of tax cuts. But one can wonder whether that's the most efficient method to stimulate the economy under the circumstances when households pay off debt. There is a large chance that much of the tax cuts will simply be saved. Indeed, research by the New York Fed shows that only around 40% of the payroll tax cuts went towards consumption, that is demand, the rest was saved.
Now, saving is useful, but when one tries to maintain demand because people save more to repair balance sheets, it's not what you aim to achieve by stimulus policy.
It can't be said either that taxes are high in the U.S., tax intake stands at just over 15% of GDP, which is both historically and internationally very low.
According to the Congressional Budget Office, federal revenues will be 15.8 percent of G.D.P. this year. The postwar average is about 18.5 percent, and taxes averaged 18.2 percent during the Reagan administration; indeed, at their lowest point in 1984, federal revenues were 1.5 percent of G.D.P. higher than they are now. [Economix]
Diminishing returns surely have set in for tax cuts. Here is Howard Gold:
For years I've tried to find any economist - left, right, or center - who could estimate the number of jobs created by the Bush tax cuts, but without success.
Certain is that in the 1990s, when taxes were actually increased (even Reagan increased the payroll tax rate from 13.4% to 15.3% in 1983), three times more jobs were created compared with the years after the Bush tax cuts. Now, comparisons like that are always fraught with difficulty, as there are so many things going on in an economy at any time that such quick conclusions on the basis of such comparisons are problematic.
But at least it shows that the economy can create lots of jobs even when tax rates were higher and job creation in the last decade (even leaving out the financial crisis or the 2001 recession) isn't particularly encouraging, despite a whopping construction boom. International evidence shows that the U.S. has a relatively low 'tax wedge' (that is, the difference between labor cost and take-home pay).
The U.S. tax wedge is just 29.5%, way smaller than Germany's, which stands at 49.8%, according to the OECD. Bruce Barlett used these figures and compared them with the percentages of workers employed as share of the working-age population (a better measure than unemployment). Here is the table - (click to enlarge):
There isn't any notable correlation between the two, suggesting taxes on labor are not a decisive factor in employment creation. Well, what about corporate tax, doesn't the U.S. have some of the highest corporate tax rates in the world? Well, perhaps, but the loopholes are such that many corporations (especially big international ones) pay little corporate tax. According to Center on Budget and Policy Priorities Director Chuck Marr:
Marr points to a basic discrepancy: While the U.S.'s top corporate tax rate of 35 percent is one of the highest in the world, the amount corporations actually end up forking over to the government is much lower, sometime as low as 4 percent. This is due to a dizzying number of deductions, write-offs, and other accounting tricks that allow corporations to legally reduce their tax burden.
Testifying to this is the great sucking sound of disappearing corporate tax dollars, which now make up just over 1%(!) of GDP.
We really fail to see what lowering corporate taxes would be able to achieve when they are this low already. How about lowering taxes on job creators? Here is Fareed Zakaria
The only thing we can think of here is some very targeted cuts for small companies. Otherwise, it's very difficult to make an even half convincing case U.S. corporations are weighed down by excessive taxes, let alone blame the tepid nature of the recovery on that. There are no figures to back that up.
Martin Wolf, the Financial Times' most eminent columnist, argues a wider point:
So I want to address two widely held, but mistaken, views. The first is that lower taxes are the principal route to better economic performance. The second is that the financial crisis is a crisis of western welfare states.
He then proceeds with a couple of charts that show no relation between the level of taxation and GDP growth (see below) or GDP per head.
He proceeds to argue that crisis hit Ireland, Spain, and (to a lesser extent) Italy had relatively low average tax rates whilst stable euro zone countries like Germany, Denmark, Austria, Sweden, and Finland, all had high average tax rates.
Only few benefit
Rising inequality played a significant role in the lead up to the financial crisis. Median wage earners shared very little in the wealth creation of the previous decades as their wages lagged productivity growth ever more. They resorted to borrowing to keep up. Building up debt against home ownership became one way to keep up spending.
But even after the crisis, the spoils of the recovery, however tepid, have been extremely concentrated among the top end
In 2010, as the nation continued to recover from the recession, a dizzying 93 percent of the additional income created in the country that year, compared to 2009 - $288 billion - went to the top 1 percent of taxpayers. In 2010, 37 percent of these additional earnings went to just the top 0.01 percent, a teaspoon-size collection of about 15,000 households with average incomes of $23.8 million. [NYT]
Until wages rise roughly in line with rises in labor productivity and inflation, demand is likely to lag supply, especially under conditions when they are already saving to pay off debt, the means by which they maintained demand before the crisis.
In the U.S., the rich lend to the rest, according to an IMF study:
In 1983, the bottom 95 percent of the U.S. population owed 62 cents in debt for every dollar they earned, the [IMF] economists find, CNNMoney reports. By 2007, that number had risen to $1.48 of debt for every $1 in earnings. Meanwhile the rich were paying off their debts, with their debt-to-income ratio dropping from 76 cents of debt for every dollar earned in 1983 to 64 cents in 2007, CNNMoney adds. [Moneynews]
Here you see exactly the problem. Wages lag productivity, so demand would lag supply if not for increased borrowing from most wage earners. After the crisis, the inequality problem hasn't disappeared, but now that the (95%) wage earners are paying off debt instead of borrowing to keep up spending, this results in a big output gap (the difference of what an economy can supply if all productive forces were employed, and what it actually produces).
So consumption is likely to remain subdued and (despite record profit and healthy balance sheets), corporate investment isn't likely to do much either, considering the lack of demand. That leaves policy levers.
Balance of evidence
The most important factor explaining the tepid nature of the recovery lies in the nature of the crisis. When households are smarting over large losses of wealth, much reduced employment and little participation in sharing the gains of the recovery, it can't be a surprise that they're reluctant spenders, preferring to pay-off debt. As long as most of the spoils go to only a few and households keep deleveraging, the recovery will be tepid at best.
The policy mix makes things needlessly complicated though. While during a normal business cycle recession, lowering interest rates is usually enough to jump-start the economy (like in the early 1980s), under the balance sheet recession of today this isn't the case. Rates are already effectively zero, but this clearly isn't enough (and that's no surprise either). No miracles can be expected of quantitative easing (QE) either.
Which leaves only fiscal policy, increasing public spending and/or reducing tax rates. There are reasons not to expect too much of cutting tax rates, especially when they are already low and likely to be saved to a large extent, as argued above. After the stimulus, the single biggest item of which was tax cuts (about 1/3), fiscal policy has actually gone into reverse.
Public spending is rising at its slowest pace and public employment has actually been decreasing for some time. With interest rates already at record lows and fiscal policy as the only lever, the problem is political.
It is somewhat curious as those that now oppose Keynesianism seemed to have a keen understanding in previous recessions, like the one in 2001. While that recession, on balance, probably didn't need any fiscal stimulus as the Fed could (and did) lower interest rates there were those who are now vehemently opposed to fiscal stimulus (like Paul Ryan) actually were in favor of fiscal stimulus.
But we are quite reassured that at least presidential candidate Romney has grasped the essentials:
if you take a trillion dollars for instance, out of the first year of the federal budget, that would shrink GDP over 5%. That is by definition throwing us into recession or depression. So I'm not going to do that, of course. [tnr.com]
While this is only one quote (and providing an insight which is not generally supported in his party) we think this provides some reassurance for those who think the U.S. will be doomed under the opposition. In fact, with decreasing public sector and taxes, one can say they already seem to have a strong influence on policy.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.