The Limp Economic Recovery, Five Years On By John H. Makin May 2014 Key Points Economic growth since the end of the 2008 financial crisis has been considerably below the average of other post—World War II recoveries. Weak growth of investments and employment and slow turnaround of consumption spending have contributed to the troubling pace of this recovery. To elevate and sustain growth, the US government must reverse disinflation before it becomes deflation, reduce marginal tax rates on capital accumulation, and provide clear leadership that focuses on building opportunity. Wags have applied the term “electile dysfunction” to characterize John Boehner’s weak performance as House majority leader. But it may be a more apt characterization of the impact of this flaccid economic recovery on Democrats’ reelection chances in the November midterm elections. Talk of better times notwithstanding, a closer examination of this recovery, which will be five years old in June, provides a clear picture of why it has been so disappointing. Weak Growth Growth since the June 2009 trough of this recovery has been considerably below average when compared to post–World War II recoveries. Figure 1 (red line) shows this recovery compared to other recoveries. The black line is the average growth rate during the five years after a trough in business cycles since 1947. The dashed lines are the standard deviation around that average. As is clear from a close look at the red line, growth in the current recovery has been below average for every quarter save two. The red line ends in the first quarter of 2014, which is currently estimated to be at growth of 1 percent. Figure 1. Real Gross Domestic Product Growth Source: US Department of Commerce, Bureau of Economic Analysis Of course, overall growth is made up of the growth of its components—consumptions, investment, and net imports. It is also important to remember that the subpar growth over the last five years has occurred at the same time that unprecedented monetary and fiscal stimulus has been applied to support the economy. However, since the end of last year, both fiscal and monetary stimulus are being withdrawn. Notwithstanding optimistic forecasts of 3 percent growth starting at the middle of this year, it remains to be seen how robust growth can be without the help of the extraordinary monetary and fiscal stimulus that has characterized the last half- decade. Weak Investment One of the most important characteristics of a robust recovery is robust investment growth. After a typical recession, with inventories depleted and demand rising, most producers wish to add to their capital stock to meet expected higher aggregate demand. The rise in investment often accompanies an improvement in animal spirits, or optimism, among producers and also may lead to further increases in investment through the so-called accelerated effect. This recovery is a disappointing exception to the rule. As figure 2 shows, investment during the recovery, since June 2009, has run far below the average pace shown by the black line and is virtually identical to the dotted line—a full standard deviation below the typical investment growth pattern during a recovery. Figure 2. Real Private Nonresidential Fixed Investment Source: US Department of Commerce, Bureau of Economic Analysis Explanations for the weak growth in investment abound. Investor uncertainty has risen in the wake of the financial crisis and substantial regulatory changes by the Obama administration, particularly in the areas of health care and financial services. This heightened investor uncertainty has penalized investment growth. Notwithstanding substantial monetary and fiscal stimulus through 2012, growth of aggregate demand has been weak, so investors have not felt the need to add to the capital stock to meet this weak growth both in the US and abroad. The weakness of investment is especially disappointing given that real interest rates, one of the determinants of investment, have been either zero or negative for most of the period since 2009. Normally, extraordinarily low borrowing costs would encourage investors to add to their capital stock. But during this expansion, the level of uncertainty has been high enough and the level of aggregate demand weak enough to discourage investment above minimal levels. Although many analysts, including the Federal Reserve, have been calling for an investment rebound for over a year, as is clear from figure 2, investment continues to crawl along at the bottom of the range for post-WWII recoveries. Of course, another problem for investment is the classic symptom of excess supply that has shown up in the behavior of price level. Inflation has been slowing over the past several years, indicating weak aggregate demand and ample productive capacity that have combined to weaken investment spending. Producers are not eager to add to capacity when the outlook for prices that they can charge for the goods they produce is bleak.1 Figure 3 shows the substandard path of inflation during this recovery. Indeed, deflation may be more of a threat than inflation to the future paths of the US and global economies. Figure 3. Inflation Calculated as the Year-over-Year Change in Monthly Urban Consumer Price Index Source: US Department of Commerce, Bureau of Economic Analysis Consumption and Wealth Another striking feature of this weak recovery has been the slow recovery of consumption spending by households, especially in view of the substantial increase in wealth that has occurred with the recovery of the stock market and the housing market. Some recovery in the stock market since 2009 and the subsequent rise in house prices since 2011 has increased total household wealth by about $25 trillion over the past several years. Normally, about 4 percent of the rise in household wealth, an important determinant of consumption, is spent. That would mean an increase in spending attributable to the wealth effect equal to about $1 trillion. Spread over five years, that would provide $200 billion per year of extra demand growth, which would show up as stronger consumption spending. Demand growth of $200 billion a year is substantial, as it adds about 1.25 percentage points of growth per year, other things being equal. Given the average growth over the past five years has been about 2.2 percentage points without the wealth effect, growth would have been truly tepid, at about a 1 percent annual pace. Figure 4 shows the path of real consumption expenditures during this expansion. Notwithstanding wealth effects, consumption has been more than a standard deviation below the typical level over most of the expansion, accounting for the widely noted weakness in aggregate demand. The persistence of weak demand growth, even with substantial help from monetary and fiscal stimulus, suggests that the aftermath of the financial crisis has left households with a strong preference for cash and liquid assets. Indeed, part of the weakness of consumption reflects the efforts of households to rebuild balance sheets through extra saving after the devastation of the 2008 financial crisis. Figure 4. Real Personal Consumption Expenditures Source: US Department of Commerce, Bureau of Economic Analysis The volatile path of the wealth effect is clear from figure 5. After a massive drop in wealth in the midst of the 2008 crisis, the percentage increase in wealth has been substantial and rapid compared to past expansions. The percentage rise in household real net worth since about 2011 has been a brisk 12 percent, leading some to observe that the wealth effect must be growing weaker in the light of the weak consumption growth that has accompanied the rapid increase of wealth. Figure 5. Year-over-Year Change in Real Net Worth of Household and Nonprofit Organizations Source: Board of Governors of the Federal Reserve System Part of the mystery regarding the weak connection between wealth and consumption is explained in figure 6, which shows the level as opposed to the growth of household real net worth over the past cycle. It is clear that the financial crisis induced a drop of household real net worth of about 25 percent over the two years prior to the cycle trough in 2009. Since then, while wealth has been rising, it just, early in 2014, reattained its precrisis level. The fact that it has required seven full years for households to regain levels of net worth last seen in 2007 probably has left them cautious and helped to account for the weak performance of consumption over this feeble expansion. Figure 6. Real Net Worth of Household and Nonprofit Organizations, Level Source: Board of Governors of the Federal Reserve System A Labor-Unfriendly Expansion The recent expansion has been characterized by especially weak growth of employment and persistence of high unemployment, notwithstanding some progress over the past year. (See figure 7.) Companies have been less than eager to add to their capital stock, and they have also been less than eager to restore levels of employment lost during the financial crisis. Part of the reason may be numerous innovations embodied in labor-saving technologies that reduce the need for labor in the production process. The ability to use smartphones and tablets to manage communication and scheduling without a human assistant come to mind. Figure 7. Civilian Unemployment Rate Source: US Department of Labor, Bureau of Labor Statistics Surely, unit labor costs, the difference between real wages and productivity growth over the past cycle, have increased at a very slow pace, about equal to a level a full standard deviation below the level that is normal for postwar expansion. (See figure 8.) Labor-saving technology has enabled firms to expand at a pace sufficient to keep up with tepid aggregate demand growth, using the existing capital stock and less labor.