Economic Recovery, Job Creation, Taxation and Interest Rates
Carlos M Pelaez

The end of the recession in mid 2009 after four consecutive quarters of contraction was followed by two consecutive quarters of expansion in the second half of 2009. The Congressional Budget Office (CBO) estimates that GDP is about 6.5 percent below potential output, which is the output that could be produced with employment of all labor and capital (http://www.cbo.gov/ftpdocs/108xx/doc10871/Summary.shtml#1045449 ). The unemployment rate of about 10.0 percent in December 2009 is twice the rate of 5.0 percent in December 2007.
The recession in the US resulted in four consecutive quarters of decline of GDP at annual percentage rates of: -2.7 QIII08, -5.4 QIV08, -6.4 QI09 and -0.7 QII09. The economy expanded again at annual percentage rates of: 2.2 QIII09 and 5.7 QIV09 (http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=2&FirstYear=2008&LastYear=2009&Freq=Qtr ). The breakdown of the contributions in percentage points at annual rates by segments of GDP of the 5.7 percent annual growth rate in QIV09 is: 1.44 of personal consumption expenditures, 3.82 of gross private domestic investment (consisting of 0.43 in fixed investment and 3.39 in change in private inventories), 0.5 percent of net exports of goods and services and 0.02 of government consumption and investment. Growth in the GDP data is driven by the slower pace of inventory reduction in the fourth quarter that contributed 3.39 percentage points to the GDP growth rate of 5.7 percent. Eventually, firms will replenish inventories as demand increases. In the recession of the 1980s the quarterly annual percentage rate of growth of GDP was: -7.9 QII80, -0.7 QIII80, 7.6 QIV80, 8.6 QI81, -3.2 QII81, 4.9 QIII81, -4.9 QIV81, -6.4 QI82, 2.2 QII82, -1.5 QIII82 and 0.3 QIV82. During the recovery phase GDP grew at the quarterly annual percentage rate of: 5.1 QI83, 9.3 QII83, 8.1 QIII83, 8.5 QIV83, 8.0 QI84, 7.1 QII84 and thereafter at rates in excess of 3 percent. Change in private inventories was a significant contributor to the rate of GDP growth in terms of percentage points only in a few quarters: 3.5 QII83, 3.1 QIV83 and 5.1 QI84. Growth was driven by personal consumption expenditures and fixed investment. The rate of unemployment increased from 6.3 percent in January 1980 to a peak of 10.8 percent in December 1982, declining at year end to: 8.3 percent in 1983, 7.3 percent in 1984 and 7.0 percent in 1985 (http://data.bls.gov/PDQ/servlet/SurveyOutputServlet ). The recovery of full employment depends on sustained high quarterly annual rates of growth of GDP originating in demand and fixed investment.
There is a critical difference in the current environment. Interest rates declined sharply in the 1980s from a high of 19.10 percent for the fed funds rate in June 1981 to 8.95 percent in December 1982, remaining between 8.95 and 11.06 percent during the quarters of high growth in the expansion phase. Average inflation measured by the consumer price index was: 13.5 percent in 1980 and 10.3 percent in 1981, declining to 3.6 percent in 1985 (ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt ). There is significant pressure on future interest rates because of the unwinding of monetary and fiscal expenditures discussed in turn.
First, fiscal deficits and debt. The baseline budget outlook of the CBO for the next ten years projects the budget deficit as percent of GDP of: -9.9 percent in 2009, -9.2 percent in 2010, -6.5 percent in 2011 and then declining deficits around 3 percent per year. The CBO finds that the 2009 deficit as percent of GDP is the largest since the end of World War II and the deficit estimated for 2010 would be the second largest. Legislation in the next few months increasing expenditures or reducing revenues could increase the projected deficit for 2010. Total federal outlays as percent of GDP have jumped to 24.7 percent in 2009, 24.1 percent in 2010 and 24.3 percent in 2011, remaining above 22 percent thereafter. Debt held by the public at the end of the year rises from 53.0 percent of GDP in 2009 to 60.3 percent in 2010, remaining above 65 percent in the remaining years.
In an application published in the Financial Times of their monumental research on financial crises, This Time is Different (http://www.amazon.com/This-Time-Different-Centuries-Financial/dp/0691142165/ref=pd_sim_b_7 ), Carmen Reinhart and Kenneth Rogoff argue that financial crises are followed by government debt crises (http://www.ft.com/cms/s/0/8844ab5a-0baa-11df-9f03-00144feabdc0.html ). Bailouts, fiscal stimulus and the sharp decline in government revenue cause increases in public debt by an average of 80 percent in three years. Sharply rising debt burdens restrict economic growth. Economic forecasts err frequently. There is risk that actual future deficits and debt may be higher than projected. Issuance of debt to finance deficits and refinance maturing debt may result in a risk premium over interest rates of federal debt because of the already high weight in investment portfolios. The CBO defines an “unsustainable federal budget” as federal debt increasing at a much faster rate than the economy as a whole (http://www.cbo.gov/ftpdocs/102xx/doc10297/SummaryforWeb_LTBO.pdf ). At some point revenue will have to increase by taxation and expenditures reduced by budget cuts, causing an adverse shock on the economy. Combinations of increasing taxes and interest rates would restrict future economic growth and employment creation.
Second, monetary stimulus. Traditional monetary stimulus during recessions consists of lowering the target of the fed funds rate, which is now at 0-0.25 percent. The Federal Open Market Committee (FOMC) will and should increase the policy rate together with the recovery of real economic activity. The zero interest rate creates significant distortions even during recessions. There is an incentive to short the dollar and go long in commodities or emerging market stocks in what is known as the carry trade (Pelaez and Pelaez, Globalization and the State Vol. II, 203-4, Government Intervention in Globalization, 70-4). Creating and unwinding carry trades cause wide fluctuations in financial variables such as exchange rates and prices of commodities and stocks. The carry trade depends on low interest rates in a major currency, such as the yen and the dollar, and high-yielding currencies or financial markets. Zero interest rates also encourage low liquidity because of the hunt for higher yields to remunerate financial assets. Higher yields are associated with significantly higher risks and unsound allocation of credit. The 1 percent fed funds target and corresponding forward guidance followed by an increase to 5.25 percent, the housing subsidy of $221 billion per year, purchase or guarantee of $1.6 trillion of nonprime mortgage-backed securities by Fannie and Freddie and the interruption of auctions of 30-year Treasury securities to lower mortgage rates constituted causal factors of the credit/dollar crisis and global recession (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4).
There are three types of information in the press release of the FOMC on January 27: (1) there is continuing improvement in the economy, even in labor markets, with sufficient resource slack that could permit 0-0.25 percent interest rates in an unknown period in the future without threatening inflation; (2) several of the credit facilities created during the crisis (Pelaez and Pelaez, Financial Regulation after the Global Recession, Table 6.3, 160-1, Regulation of Banks and Finance, 224-6) are phasing out on their own; and (3) the purchase of mortgage-backed securities will continue until reaching $1.25 trillion and of agency securities to about $175 billion but then cease in accordance with economic conditions (http://www.federalreserve.gov/newsevents/press/monetary/20100127a.htm ). The Fed is also considering the use of the rate paid on deposits by banks as the new policy rate, replacing the fed funds rate (http://www.bloomberg.com/apps/news?pid=20601087&sid=aHWsoTqQqTi0 ). Both rates reflect the marginal costs of banks.
An innovative policy used by the Fed during the credit crisis is the change in composition and size of its balance sheet (Pelaez and Pelaez, Regulation of Banks and Finance, 224, Financial Regulation after the Global Recession, 167-9, see The Global Recession Risk, 83-107). The Fed balance sheet for the week ending on January 27 shows total credit of $2234 billion of which $1912 billion is in “securities held outright,” consisting of $776 trillion in US Treasury securities, $973 billion in mortgage-backed securities and $162 billion in Federal agency securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). A major source of financing of the portfolio of securities of the Fed is $1104 billion of reserve balances with the Federal Reserve Banks. At some point the Fed will begin the process of unwinding the balance sheet. Interest rates paid on bank balances at the Federal Reserve Banks will have to increase to prevent withdrawals of those balances that banks could use in lending to numerous sound projects of clients. Increasing demand for bank loans would increase lending interest rates. The combined retained portfolio of Fannie and Freddie is around $1.6 trillion and that of the Fed another $1.6 trillion. Actual or expected sales of these portfolios could exert upward pressure on long-term interest rates. Increase in short-term fed funds rates and long-term rates of mortgage-backed securities could shift upward the entire yield curve with much sharper difference between the short and long-ends.
Policy should focus on avoiding tax and interest shocks that could slow the economic recovery, preventing full employment. It may be impossible to perfectly smooth the expansion path of the economy but the similar experience in the 1980s provides evidence that the economy can grow rapidly without interruption, reducing the rate of unemployment by several percentage points. Increases in federal budget revenue and increases in interest rates will be unavoidable. The only magic that may remain is not following policies of excessive spending by being more creative in attaining indispensable goals with parsimonious programs. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)