The Slowing Economy and the Stimulus Debate

 

The Slowing Economy and the Stimulus Debate

Carlos M. Pelaez

The rate of growth of the US economy has declined from 5 percent in the final quarter of 2009 to 3.7 percent in the first quarter of 2010 and 2.4 percent in the second quarter of 2010. Various economic indicators suggest deceleration. The objective of this post is to relate the slowing economy to the growing debate on the effectiveness of the fiscal stimulus and restructurings of major segments of economic activity. The slowing economy is analyzed in (I) by means of new data and comparisons with a similar earlier recession. The essence of the stimulus debate is considered in (II). Financial turbulence is illustrated with data in (III), economic indicators in (IV) and interest rates in (V). The conclusion is in VI.

I Slowing Economy. The Bureau of Economic Analysis (BEA) of the Department of Commerce released the National Income and Product Accounts on Jul 30 together with important revisions for 2007-2010 (http://www.bea.gov/newsreleases/national/gdp/2010/pdf/gdp2q10_adv.pdf ). Economic activity is measured by GDP or product accounts and expressed in quarter to quarter percentage changes that are adjusted for seasonality and converted into an equivalent annual rate. GDP increased at the seasonally-adjusted annual rate of 2.4 percent in the second quarter of 2010, which is the rate equivalent to growth from the first into the second quarter that would occur if repeated over four quarters, adjusting for seasonal factors in the second quarter. Table 1 shows three blocks of data. The first block provides the GDP rate in the quarters of recession and in recovery from the third quarter of 2008 (3Q08) to the latest preliminary estimate for the second quarter of 2010 (2Q10). A common misleading statement is to compare the current recession, with the grandiose title of the “Great Recession,” to the Great Depression of the 1930s, in efforts to propose or defend policies. Systematic review of the rich academic literature on the 1930s reveals two entirely different economic contractions (Pelaez and Pelaez, Regulation of Banks and Finance, 198-217). In both the current recession and the Great Depression, government policy was important in causing the recession. There is still time to reverse policy so that it does not prolong unemployment and idle capacity while implementing damaging regulation as it actually happened in the 1930s. During the contraction of the 1930s, real GDP declined in four consecutive years: -8.6 percent in 1930, -6.4 percent in 1931, -13.0 percent in 1932 and -1.3 percent in 1993 for cumulative decline of -26.5 percent (BEA cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 151). The most relevant period for comparison of the current situation is not with the Great Depression much the same as pointed out by Franco Modigliani relative to a speech in 1981 in which President Reagan “began by suggesting that ‘we are in the worst economic mess since the Great Depression,’ a statement than an objective review of the situation would find highly exaggerated” (Franco Modigliani, Reagan’s economic policies: a critique. Oxford Economic Papers 40 (3), 399). The decline of output in the current recession is now estimated by the BEA at -4.1 percent. The correct comparison is precisely with the early 1980s as shown in Table 1 and routinely analyzed in this blog as well as by the Wall Street Journal (http://professional.wsj.com/article/SB10001424052748703995104575389430430274968.html

). The main reason is not to compare different approaches to policy to score partisan political points but rather to compare the deepest contraction in recent times, which had similar depth and global spread. The causes and resolutions of both crises and their dimensions were different. There is also hope in the comparison because the economy never recovered from the Great Depression, maintaining high idle capacity and double-digit unemployment rates (Harold Cole and Lee Ohanian cited in Pelaez and Pelaez, Regulation of Banks and Finance, 215-7) but the expansion phase in the 1980s was in the desired V shape with eventual recovery of employment.

The second line of Table 1 shows that the contraction occurred in four quarters from 3Q08 to 2Q09 at high annual equivalent rates for cumulative -4.1 percent. The third line of Table 1 shows similar rates of contraction also in four quarters. The hope in Table 1 is in the last line 6 showing rates of GDP growth between 7.1 percent and 9.3 percent in five consecutive quarters preceded by 5.1 percent in 3Q08 and followed by rates in excess of 3 percent after 3Q84. The rates of GDP growth in line 2 after the recovery began in 3Q09 are mediocre so far: 1.6 percent in 3Q09, 5.0 percent in 4Q09, 3.7 percent in 1Q10 and 2.4 percent in 2Q10. In the first year of strong recovery the rate of growth jumped from 2.2 percent in 2Q82 to 9.3 percent in 2Q83 while in the current recession the rate of growth has increased from a decline of -0.7 percent in 2Q09 to 2.4 percent in 2Q10. These rates of growth if continued will not solve the worrisome labor market conditions in the US.

Table 1, GDP Seasonally Adjusted Annual Rates %

3Q08	4Q08	1Q09	2Q09	3Q09	4Q09	1Q10	2Q10
-4.0	-6.8	-4.9	-0.7	1.6	5.0	3.7	2.4
2Q81	3Q81	4Q81	1Q82	2Q82	3Q82	4Q82
-3.2	4.9	-4.9	-6.4	2.2	-1.5	0.3
1Q83	2Q83	3Q83	4Q83	1Q84	2Q84	3Q84	4Q84
5.1	9.3	8.1	8.5	8.0	7.1	3.9	3.3

Source: http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=2&FirstYear=2007&LastYear=2008&Freq=Qtr

 

The “headline” number of GDP of 2.4 percent growth in 2Q10 is disappointing but detailed analysis of the data in Table 2 reveals some hope. Change in private inventories was a significant contributor to the rate of GDP growth in terms of percentage points (pp) only in a few quarters: 3.5 in 2Q83, 3.1 in 4Q83 and 5.1 in 1Q84. Growth was driven by personal consumption expenditures and fixed investment. Table 2 provides the critical breakdown of the contributions to the rate of GDP growth by segments. Change in inventories was a major driver of GDP growth in 4Q09, 2.83 pp, accounting for most of gross investment of 2.7 pp, and 2.64 pp for inventory change with 3.044 pp for gross investment in 1Q10. Restocking decreased in 2Q10 with change in inventories contributing 1.05 pp. Personal consumption expenditures (PCE) have contributed positively in all quarters, including 1.15 pp in 2Q10. The doubt is whether PCEs will continue to be strong in current uncertainty and weak labor markets. An important item is net exports that had a negative contribution of -2.78 pp in 2Q10. The BEA report measures an increase of 10.3 percent in real exports of goods and services in 2Q10 relative to 11.4 percent in 1Q10 but an increase in real imports of goods and services of 28.8 percent in 2Q10 relative to 11.2 percent in the prior quarter.

Table 2, Percentage Point Contributions to the Growth Rate of GDP

Segment	3Q09	4Q09	1Q10	2Q10
Total	1.6	5.0	3.7	2.4
PCE	1.41	0.69	1.33	1.15
Gross Investment	1.22	2.7	3.044	3.14
Fixed Investment	0.12	-0.12	0.39	2.09
Change Inventories	1.1	2.83	2.64	1.05
Net Exports	-1.37	1.9	-0.31	-2.78
Gov	0.33	-0.28	-0.32	0.88

Source: same as Table 1.

 

There is growth and recovery but it is not enough relative to what is required for job creation. Table 3 provides comparison of unemployment and the fiscal position of the US currently and in the 1980s. The second block of numbers provides both hope and caution. The rate of unemployment rose from 7.6 percent in 1981 to 9.6 percent in 1983 but collapsed to 7.5 percent in 1984 and then to 5.5 percent in 1988. It takes time in recovering employment from sharp contraction even with rates of growth in five consecutive quarters ranging from 7.1 to 9.3 percent; high sustained rates of economic growth must be maintained in providing relief to job stress. Table 3 also shows that the current deficits as percent of GDP have been much higher after 2009, actually the highest since World War II and around 10 percent of GDP, while the deficits in the 1980s peaked at 6.0 percent in 1983 and declined to 3.1 percent by 1988. Government revenue remained at close to the historical average of 18 percent of GDP in the 1980s while it collapsed to slightly below 14.8 percent in 2009 and 14.9 percent in 2010. Government expenditures or outlays increased to 24.7 percent of GDP in 2009 and 24.3 percent in 2010. The projections of expenditures and outlays after 2012 are from the alternative scenario of the Congressional Budget Office (CBO) to illustrate the argument that bringing government revenue above 20 percent of GDP to meet expenditures of more than 20 percent of GDP may be unfeasible and could cause a long-term path of unsustainable government debt. Continuing stress in labor markets will coincide with a tough fiscal situation.

Table 3, Rate of Unemployment and Deficit, Outlays and Revenues as Percent of GDP

	2007	2008	2009	2010	2011	2012	2013	2014
Un	4.6	5.8	9.3	9.5J
Deficit	-1.2	-3.2	-9.9	10.0	-9.2	-5.6	-4.2	-3.9
Exp	19.6	20.7	24.7	24.3	24.5	22.9	22.6	22.8
Rev	18.5	17.5	14.8	14.9	16.9	17.6	18.2	18.7
	1981	1982	1983	1984	1985	1986	1987	1988
Un	7.6	9.7	9.6	7.5	7.2	7.0	6.2	5.5
Def	-2.6	-4.0	-6.0	-4.8	-5.1	-5.0	-3.2	-3.1
Exp	22.2	23.1	23.5	22.2	22.8	22.5	21.6	21.3
Rev	19.6	19.2	17.5	17.3	17.7	17.5	18.4	21.3

Source:

http://www.bls.gov/cps/cpsaat1.pdf

http://www.whitehouse.gov/omb/budget/Historicals/

https://www.cbo.gov/doc.cfm?index=11659

 

II Stimulus Debate. There are doubts if the growth of the US economy will be sufficient to absorb 27 million people currently in job stress composed of: 14.6 million unemployed (of whom long-term unemployed of 6.8 million or 45.5 percent who have been unemployed more than 27 weeks), 8.6 million working part-time because they could not find a better job, 2.6 million marginally attached to the labor force (who wanted and were available for work and had searched for work in the prior 12 months) and 1.2 million discouraged workers (who believe there is no job for them or had not searched for work in the prior four weeks) (http://www.bls.gov/news.release/pdf/empsit.pdf ). The economic strategy for job creation in the short run consists of the American Recovery and Reinvestment Act of 2009 (ARRA) with fiscal stimulus of $787 billion. The Council of Economic Advisors (CEA) finds in its report of Jul 14, 2010, that “the ARRA has raised employment relative to what it otherwise would have been by between 2.5 and 3.6 million” and that “ARRA has raised the level of GDP as of the second quarter of 2010, relative to what it otherwise would have been by between 2.7 and 3.2 percent” (http://www.whitehouse.gov/files/documents/cea_4th_arra_report.pdf ). Counterfactual claims consist of empirical issues that are quite difficult to measure such as “what would have been otherwise.” These counterfactuals abound in economics but are almost impossible to prove rigorously (Pelaez and Pelaez, Globalization and the State, Vol. I, 17, 124-5). In this case, proving that the stimulus “saved” millions of jobs requires detailed data on the US economy with and without the stimulus while data are only observed with the stimulus and it is very difficult to separate the effects of alternative hypotheses. Persistent high unemployment raises doubts on the effects of the fiscal stimulus. There is a widely anticipated tax increase after the November elections to recover the fiscal credibility of the US. The effects of legislated taxes on the rate of growth of GDP are extremely difficult to measure because many other variables influence GDP growth such as monetary policy, natural disasters and expectations and so on. The professional literature has been enriched by a current essay by Christina D. Romer and David H. Romer (The macroeconomic effects of tax changes: estimates based on a new measure of fiscal shocks. American Economic Review 100 (Jun 2010): 763-801 http://elsa.berkeley.edu/~dromer/ ). They created a sample that intends to isolate legislated tax changes that would be “exogenous,” or unrelated to other factors that simultaneously affect GDP growth. A similar method is used revealingly by Romer and Romer to measure lags of monetary policy effects on income and prices (A new measure of monetary shocks: derivation and implications. American Economic Review 94 (4): 1055-84 cited in Pelaez and Pelaez, Regulation of Banks and Finance, 102). The major finding in the 2010 essay by Romer and Romer is that “our results indicate that tax changes have very large effects on output. Our baseline specification implies that an exogenous tax increase of one percent of GDP lowers real GDP by almost three percent. We find suggestive evidence that tax increases to reduce an inherited budget deficit do not have the large output costs associated with other exogenous tax increases” (The macroeconomic effects of tax changes, 799). Michael J. Boskin, Professor at Stanford and fellow at the Hoover Institution, warned in 2008 that permanently expanding government with taxes is not sound policy in hard times (http://professional.wsj.com/article/SB10001424052748703724104575378751776758256.html ). Future higher taxes to finance the current deficits will deteriorate the economy and are widely anticipated. There is active debate on the fiscal stimulus that is surveyed by the Wall Street Journal (http://professional.wsj.com/article/SB10001424052748704720004575376923163437134.html?mod=wsjproe_hps_LEFTWhatsNews ). This debate will be actively reviewed by future posts in this blog. Sudden regime change can be highly disruptive. The economy of Russia in transition to freer markets declined throughout most of the 1990s with -14.5 percent in 1992 and -12.7 percent in 1994 (Pelaez and Pelaez, Government Intervention in Globalization, Vol. II, 102-5). The legislative restructurings, regulatory shocks and mandates impose radical changes in the way of making business that is affecting investment decisions by business and families as well as hiring decisions. A strong positive confidence shock will reignite the economy, creating far more jobs than another construction project with negative present value and eventual financing of that waste by taxpayers. There is a conflict between economic recovery and structural changes for alleged long-term benefits that disrupt current economic activity, creating a perverse tradeoff of persistent high unemployment now for alleged benefits decades ahead.

III. Financial Turbulence. Financial turbulence has moderated in the past two weeks. Investors remain cautious by managing positions more actively instead of sitting on positions based on anticipated trends. The percentage performance of major US indices to Jul 30 was: DJIA -6.6 from the recent peak on Apr 26 and 0.4 in the week; S&P 500 -9.5 from the recent peak on Apr 23 and -0.1 in the week; and NYSE Financial -11.4 since Apr 15 and 2.3 in the week. The percentage performance of major world stock markets from Apr 15 to Jul 30 was: Dow Global -11.1 and 1.0 in the week; Dow Asia Pacific TSM -7.0 and 1.3 in the week; Shanghai -16.7 and 2.5 in the week; and STOXX Europe 50 -8.7 and 0.2 in the week. The euro moved sideways, trading at $1.3045/EUR on Jul 30. The dollar has gained 16.0 percent relative to the euro since the recent trough on Nov 25, 2009, and dropped -1.0 percent in the week. The DJ UBS commodity index fell 7.4 percent since the recent peak on Jan 6 and gained 3.3 percent in the week. The 10-Treasury traded at 2.905 percent on Jul 23 as funds flowed back into risk positions. There are still risks in the world economy from possible slowdown in China that could affect commodities and interregional trade in Asia; sovereign risks in Europe and doubts on bank exposures to countries with troubled debt; and the worldwide impact of US slower growth and persistent unemployment.

IV Economic Indicators. Real estate continues to be weak and the economy is advancing at a modest pace relative to past recovery from a sharp contraction. New home sales in Jun stood at the seasonally adjusted annual rate of 330.000, jumping by 23.6 percent relative to the revised rate of 267.000 for May 2010 but still below by 16.7 percent of the rate in Jun 2009 (http://www.census.gov/const/newressales.pdf ) and 76.0 percent below the rate of 1,374,000 in Jun 2005 (http://www.census.gov/const/newressales_200506.pdf ). Durable goods orders are very volatile, especially the transportation component with aircraft segments, posing difficulty in identifying trends. New orders for manufactured durable goods fell by 1 per cent in Jun after a fall of 0.8 percent in May. The decline excluding transportation was 0.6 percent and 0.7 percent excluding defense (http://www.census.gov/manufacturing/m3/adv/pdf/durgd.pdf ). The Beige Book of the Fed finds continuing growth in economic activity, with some districts reporting steady economic activity and moderate growth in districts reporting improvement (http://www.federalreserve.gov/fomc/beigebook/2010/20100728/default.htm ). Initial claims of unemployment insurance stood at 457,000 in the week ending Jul 24, falling 11,000 from the prior week (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). Initial claims have stabilized around 450,000 in 2010, suggesting weak labor market conditions. The Chicago ISM index of business jumped from 61.5 in Jun to 64.9 in Jul, suggesting growth from the earlier month (https://www.ism-chicago.org/chapters/ism-ismchicago/files/ISM-C%20July%202010.pdf ).

V. Interest Rates. The yield curve of the US shifted downwardly with the 10-year Treasury falling to 2.91 percent from 2.99 percent a week ago and 2.94 percent a month ago because of the use of Treasuries and highly-graded fixed income securities as safe haven from risk exposures. The 10-year German government bond traded at 2.66 percent with negative spread relative to the 10-year Treasury of 25 basis points (http://markets.ft.com/markets/bonds.asp?ftauth=1280673329435 ). The US yield curve continues to show a peculiar shape of yields: 0.14 percent for 1 month, 0.20 percent for 6 months, 0.55 percent for 2 years, 1.60 percent for 5 years, 2.91 percent for 10 years and 3.99 percent for 30 years (Ibid). The 2007-2009 credit crisis and global recession were caused by prolonged low interest rates near zero by the Fed in 2003-2004, artificial lowering of mortgage rates, housing subsidy of $221 billion per year and purchase or acquisition of $1.6 trillion of nonprime mortgages by Fannie and Freddie (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). Interest rates are again near zero with the added policy restriction of the Fed balance sheet of $2.308 trillion that includes a portfolio of $2.043 trillion of long-term securities ($712 billion of US Treasury bonds and notes, $159 billion of Federal agency debt securities and $1117 billion of mortgage-backed securities) (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). The recovery is not only threatened by widespread and high tax increases but also by interest rate increases as the Fed unwinds more than two trillion dollars of securities acquired to lower long-term interest rates. There may be merit in explaining the surge of commodity prices in the carry trade of shorting the dollar and buying commodity futures that was induced by the zero interest rate on fed funds (Pelaez and Pelaez, Globalization and the State, Vol. II, 203-4, Government Intervention in Globalization, 70-4). The rise of oil to $149/barrel in 2008 during a major world crisis can only be explained by carry trade positions; the decline to less than $60/barrel can only be explained by the unwinding of those positions. Exotic monetary policy has complicated the recovery and threatens its strength. The President of the Federal Reserve Bank of St. Louis warns that the US may be caught in a near zero nominal interest rate and deflationary steady state similar to that of Japan if it continues to maintain a low nominal interest rate (http://www.stlouisfed.org/ ). Policy could consist of increasing the nominal interest rate to 2.8 percent consistent with inflation of 2.3 percent that is attained at the intersection of the Irving Fisher equation relating real rates of interest to the nominal interest rate discounted by the expectation of inflation and the Taylor Rule relating the central bank policy rate, or fed funds rate, to inflation, the deviation of output from trend and the discrepancy of inflation from the target inflation desired by the central bank (John B. Taylor cited in Pelaez and Pelaez, Regulation of Banks and Finance, 111). There is a tough adjustment of monetary policy facing the Fed and other central banks around the world. Experimenting with exotic policy should be reserved for working papers.

VI Conclusion. The US is fighting a perverse tradeoff of continuing unemployment or underemployment of 27 million persons with a rush during a tough recovery of economic activity of legislative restructurings, regulatory shocks and mandates. A policy shift could move the economy toward higher growth rates and job creation. (Go to http://cmpassocregulationblog.blogspot.com/ http://sites.google.com/site/economicregulation/carlos-m-pelaez)

http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10 )