The Recovery From the 2008 Collapse That Could Have Been: The Impact of the Fiscal Cuts

GDP Recovery Path with Govt Growth at Historic Average, 2004Q4 to 2013Q2

A.  Introduction

Previous posts on this blog (including this older one from 2012) have discussed how the sluggish recovery from the 2008 economic collapse could have been avoided if one had allowed government spending to grow as it had during Reagan’s term.  This post will look in more detail at what the resulting path for GDP would have been if government spending had followed the path as it had under Reagan, or even had simply been allowed to grow at its normal historical rate.

The 2008 collapse was of course not caused by fiscal actions, but rather by the bursting of the housing bubble, and its consequent impact both in bankrupting a large share of an overly-leveraged financial system and in causing household consumption to fall as many homeowners struggled to repay mortgages that were now greater than the value of their homes.  Faced with the high unemployment resulting from this, an expansion of government spending would have supported the demand for output and hence for workers to produce that output.  And initially, fiscal spending did indeed grow.  This growth (along with aggressive action by the Fed) did succeed in turning around the steep slide of the economy that Obama faced as he took office.  But since 2009 government spending has been cut back, and as a result the recovery of GDP has been by far the slowest in any cyclical downturn of the last four decades.

This blog post will look at alternative scenarios of what the recovery path of GDP could have been, had government spending not been reduced.  Two primary alternatives will be examined.  In the first, government spending is allowed to grow from the point President Obama took office at a rate equal to its average rate of growth over the period 1981 to 2008.  In the second, government spending is allowed to grow from the onset of the recession (i.e. from the fourth quarter of 2007) at the same rate as it had during the Reagan years, following the downturn that began in the third quarter of 1981.

B.  Government Spending Growth at the Historic Average Rate

In the first scenario, real government spending on goods and services (as measured in the GDP accounts, and inclusive of state and local government as well as federal) is allowed to grow at a rate of 2.24% per year.  This is the average rate of growth for government spending over the 28 years from 1980 to 2008.  This was a modest growth rate, and spanned the presidencies of three Republicans (Reagan and the two Bushes) for 20 of the 28 years, and one Democrat (Clinton) for 8 of the 28 years.  The 2.24% growth rate was substantially below the growth rate of GDP of 3.04% over this same period (note this is for total GDP, not per capita).  As a result, real GDP grew by over 50% more over this period than government spending did.  But this modest pace of government spending growth was substantially more than the absolute fall in government spending during Obama’s term in office.

Note that this path for government spending is not some special rate faster than the historical average, as would normally be called for in a downturn when fiscal stimulus is needed because aggregate demand in the economy is less than what is needed for full employment.  Rather, it is just the historical average rate.  This should be seen as a neutral path, with government spending neither purposely stimulative, nor purposely contractionary.

This path for government spending is shown as the orange line in the following, where the path is superimposed on the graph presented in the earlier blog post of such paths of government spending in each of the downturns the US has faced since the 1970s:

Recessions - Govt Cons + Inv Expenditures Around Peak, 12Q before to 22Q after, with growth at avg historical rate

Maintaining government spending growth at the historical 2.24% rate would have led to government spending well below that seen during the Reagan years (in the recoveries from the July 1981 and January 1980 downturns), roughly where it was in the recoveries from the November 1973 and March 2001 downturns, and well above where it was in the recoveries from the July 1990 downturn (during the Clinton years) and of course the December 2007 downturn (under Obama).  Government spending in the current downturn (the brown curve in the graph) has fallen substantially during the period Obama has been in office.

The graph at the top of this post then shows what the GDP path would have been if government spending would have been allowed to grow at the historic average rate.  The impact will depend on the multiplier.  As was discussed in the earlier post on fiscal multipliers, the multiplier for the US in this period of high unemployment and short-term interest rates of close to zero will be relatively high.  But for the purposes here, we will run scenarios of multipliers of 1.5, of 2.0, and of 2.5.  This will span the range most economists would find reasonable for this period.

The results indicate that had one simply had government spending grow at its historic average rate, the economy would likely now be at or close to potential GDP, which is what GDP would be at full employment.  But because of the fall in government spending since 2009 rather than this increase, current actual GDP is over 6% below potential GDP, and unemployment is high.  (Potential GDP comes from the CBO estimates used in its May 2013 budget projections, but adjusted to reflect the methodological change made by the BEA in July 2013.  Due to these adjustments, including for the GDP deflators used, the potential GDP path is not as “smooth” as one would normally see.  But it will be close.)

Republicans have argued that we cannot, however, afford higher government spending, even if it would lead the economy back to full employment, as it would lead to an even higher public debt to GDP ratio.  But as was discussed in a recent post on this blog on the arithmetic of the debt to GDP ratio, it is not necessarily the case that higher government spending will lead to a higher ratio.  The Republican argument fails to recognize both that GDP will higher (due to the multiplier, and indeed a relatively high multiplier in the current conditions of high unemployment and close to zero short-term interest rates), and that a higher GDP will generate higher tax revenues due to that growth, which will off-set at least in part the impact on the deficit of the higher spending.

The resulting paths for the debt to GDP ratios by fiscal year, using a 30% marginal tax rate for the higher income, would be:

Public Debt to GDP with Govt Growth at Historic Average, FY2009 to FY2013

The impact of the higher government spending is to reduce the debt to GDP ratios over this period.  The higher government spending leads to a higher GDP, and this higher GDP along with the extra tax revenues generated at the higher output means the debt rises by proportionately less.  The ratios fall the most, as one would expect, the higher the multiplier.  If one is truly concerned about the burden of the debt, one should be supportive of fiscal spending in this environment to bring the economy quickly back to full employment.  The debt burden will then be less.

The debt to GDP ratios still rise over these years.  This serves to point out that the assertion made by the Republicans that the public debt to GDP ratio has risen so much during Obama’s term due to explosive spending under Obama is simply nonsense.  The debt to GDP ratios rose not due to higher government spending, but primarily due to the economic collapse and slow recovery, which has decimated tax revenues.  With higher government spending, the debt to GDP ratios would have been lower.

C.  Government Spending Growth at the Rate During the Reagan Years

The second set of scenarios examine what the path of GDP would have been had government spending been allowed to grow, following the onset of the downturn in December 2007, at the same pace as it had during the Reagan years following the onset of the July 1981 downturn.  The path followed is shown as the green line in the graph above on government spending around the business cycle peaks.

The resulting recovery in GDP during the current downturn would have been significantly faster:

GDP Recovery Path with Govt Growth at Reagan Rate, 2004Q2 to 2013Q2

If government spending had been allowed to grow under Obama as it had under Reagan, the economy likely would have reached full employment in 2011 (multipliers of 2.5 or 2.0), or at least by the summer of 2012 (multiplier of just 1.5).  That is, the economy would have been at full employment well before the election.

The deb to GDP ratios would also have been less than what they actually were:

Public Debt to GDP with Govt Growth at Reagan Rate, FY2008 to FY2013

Note that for these calculations I assumed that once the economy reached full employment   GDP (potential GDP), that government spending was then scaled back to what was then necessary to maintain full employment, and not over-shoot it.  Hence the curves for the 2.5 and 2.0 multipliers move parallel to each other (and are close to each other) once this ceiling has been reached.

D.  Conclusion

Fiscal spending was not the cause of the 2008 collapse.  Rather, the cause was the bursting of the housing bubble, and the resulting bankruptcy of a large share of the financial system, as well as the resulting reduction in household spending when many homeowners found that their homes were now worth less than their mortgages.

But following an initial increase in government spending, in particular as part of the fiscal stimulus package passed soon after Obama took office, government spending has been cut back.  The scenarios reviewed above indicate that had government spending merely been allowed to grow at its normal historical rate from when Obama took office (i.e. even without the special stimulus package), the US would by now be at or at least close to full employment.  And if government spending had grown as it had during the Reagan years, the economy would likely have reached full employment in 2011.

There is no need to introduce some special factor to explain why GDP is still so far below what it would be at full employment.  There is no need to assume that something such as “business uncertainty” due to Obama, or new and burdensome regulations, have for some reason led to this slow recovery in GDP.  Rather, the sluggish recovery of GDP and hence of employment can be explained fully by the policies that have kept government spending well below the historical norms.

The Sluggish Recovery: Fiscal Drag Continues to Hold Back the Economy

Recessions - GDP Around Peak, 12Q before to 22Q after

I.  Introduction

The recovery from the 2008 economic collapse remains sluggish, with GDP growing in the first half of 2013 at an annualized rate of only 1.4% (according to recently released BEA estimates).  And based on fourth quarter to fourth quarter figures, GDP grew by only 2.0% in 2011 followed by just 2.0% again in 2012.  As a result, the unemployment rate has come down only slowly, from a peak of 10.0% in 2009 to a still high 7.4% as of July.

Conservatives have asserted that the recovery has been slow due to huge and unprecedented increases in government spending during Obama’s term, and that the answer should therefore be to cut that spending.  But as has been noted in earlier posts on this blog, direct government spending during Obama’s term has instead been falling.  This reduction in demand for what the economy can produce has slowed the recovery from what it would have been.

This blog will update numbers first presented in a March 2012 post on this blog, which compared the paths of GDP, government spending, and other items in the periods before and after the start of each of the recessions the US has faced since the 1970s.  That earlier blog post looked at the paths of GDP and the other items from 12 quarters before the business cycle peak (as dated by the NBER, the entity that organizes a panel of experts to date economic downturns) to 16 quarters after those peaks (when the downturns by definition begin).  The figures were rebased to equal 100.0 at the business cycle peaks.  We now have an additional year and a half of GDP account data, so it is now possible to extend the paths to 22 quarters from the start of the recent downturn in December 2007.  This has therefore been done for all.

The conclusions from the earlier post unfortunately remain, but are even more clear with the additional year and a half of observations.  GDP growth remains sluggish, government spending has fallen by even more, and residential investment remains depressed (although it has finally begun to recover).

II.  The Path of Real GDP

The graph at the top of this post shows the path followed by real GDP in the periods from 12 quarters before to 22 quarters after the onset dates of each of the recessions the US has faced since the 1970s.  The sluggish recovery from the current downturn is clear.

The economy fell sharply in the final year of the Bush administration, and then stabilized quickly after Obama took office.  GDP then began to grow from the third quarter of 2009 and has continued to grow since.  But the pace of recovery has been slow.  By 22 quarters from the previous business cycle peak, real GDP in the current downturn is only 4% above where it had been at that peak.  At the same point in the other downturns since the 1970s, real GDP was between 15% and 20% above where it had been at the previous peak.  This has been a terrible recovery.

 III.  The Path of Government Spending

How has this recovery differed from the others?  To start to understand this, look at the path government spending has taken:

Recessions - Govt Cons + Inv Expenditures Around Peak, 12Q before to 22Q after

Direct government spending has fallen in this recovery, in sharp contrast to the increases seen in the other recoveries.  Real government spending was 26% higher by 22 quarters after the onset of the July 1981 recession (the green line) during the Reagan presidency, and 13% higher at the same point in the recovery from the March 2001 recession (the plum colored line) during the Bush II presidency.  While both Reagan and Bush claimed to represent small government conservatism, government spending instead rose sharply during their terms.

In contrast, in the current downturn direct government spending is now 1.2% below what it had been at the start of the recession in December 2007.  Furthermore, it is worth noting that while it rose in the final year of the Bush presidency and then in the first half year after Obama took office (a major reason why the recovery then began), it has since fallen sharply.  Government spending is now almost 7% below where it had been in mid-2009, a half year after Obama took office.  Such a decline (indeed no decline) has ever happened before, going back at least four decades, as the economy has struggled to recover from a recession.  The closest was during the Clinton years, when government spending was essentially flat (a 1% increase at the same point in the recovery).

Note that the measure of government spending shown here is that for total government spending on consumption and investment (i.e. all government spending on goods and services).  This is the direct component of GDP.  Government spending can also be measured by including transfer payments to households (such as for Social Security or unemployment insurance), but as was noted in the earlier blog post from March 2012, the results are similar.  Note also that the government spending figures include spending at the state and local levels, in addition to federal spending.  While we speak of government spending as taking place during some presidential term in office, the decisions are made not simply by the president but also by many others (including state and local officials, and the Congress) in the US system.  But the president at the time is typically assigned the blame (or the credit) for the outcome.

IV.  The Path of Residential Investment

The current downturn and recovery also differs from the others by the scale of the housing collapse, and consequent fall in residential investment:

Recessions - Residential Investment Around Peaks, 12Q before to 22Q after

The build up of the housing bubble from 2002 to 2006 was unprecedented in the US, and the collapse then more severe.  As the graph above shows, there has been a start in the recovery of residential investment from the lows it had reached in 2009 / 2010, but it is still far below the levels seen in previous downturns.

Housing had been overbuilt during the bubble in the Bush years, leaving an oversupply of housing once the bubble burst.  And while supply was in excess, demand for housing was reduced due to the severe recession.  As was discussed in an earlier blog post on the housing crisis, the result was a doubling up of households as well as delays in household formation as young adults continued to live with their parents.  Residential investment therefore collapsed, and has recovered only very slowly.

V.  The Path of Household Debt

The housing bubble also led to over-indebtedness of households.  Nothing of this sort at all close to this scale had ever happened before in the US.  With the lack of regulation and oversight of the financial sector during the Bush administration, banks and other financial entities launched and aggressively marketed and sold financial instruments that led to a bidding up of home prices.  But these new financial instruments were only viable if housing prices continued to rise forever.  When the housing bubble burst, widespread defaults followed.  And those households who did not default struggled to pay down the debts they had taken on, for assets now worth less than the size of the debts tied to them.

The result was a sustained fall in household debt (three-quarters of which is mortgage debt) in the period of the downturn:

Recessions - HH Debt Around Peak, 12Q before to 22Q after

This pay-down of debt had never happened before, and is in stark contrast to the rise in household debt seen in all the other downturns of the last four decades.

VI.  The Path of Personal Consumption Expenditure

Households struggling to pay down their debt have to cut back on their consumption expenditures.  This brings us to the last element of the current recovery I would like to highlight:  the especially slow recovery in household consumption.  That path of consumption during the current downturn stands out again in contrast to the paths followed in the other downturns and recoveries of the last four decades in the US:

Recessions - Personal Consumption Around Peaks, 12Q before to 22Q after

The difference is stark.  Households could spend more in the prior recoveries in part because they could continue to borrow (see the graph on household debt above).  In this recovery, households have instead had to pay down the debts they had accumulated in the housing bubble years, and could increase their household consumption only modestly.

VII.  Conclusion

The recovery in the current downturn has been disappointing.  GDP has grown since soon after Obama took office, but has grown only slowly, and has been on a path well below that seen in other recoveries.

There are a number of reasons for this.  Household consumption has kept to a low path as households have struggled to repay the over-indebtedness they had accumulated during the housing bubble years.  Residential investment collapsed as well following the bubble, is only now starting to recover, and remains far below the levels seen at similar points in other recoveries.
And government spending has been allowed to fall during Obama’s term.  This had never happened before in the previous downturns.  Indeed, while real government spending rose by 26% at the same point in the economic recovery during the Reagan presidency, it has been reduced by over 1% in this recovery (and reduced by 7% from what it had been a half year after Obama took office).
The reduction in government spending reduced the demand for what the economy could have produced.  In this it was similar to the reduced demand resulting from lower residential investment or lower household consumption expenditure.  All these reductions in demand reduced GDP, reduced the demand for workers, and hence increased unemployment.  But while residential investment and household consumption can only be influenced indirectly and highly imperfectly by government policy, government has direct control over how much it spends.  That is, government can decide whether to build a road or a school building, and doing so will employ workers and will lead to an increase in GDP.  Hence government spending is a direct instrument that can be used to raise growth and employment, should the government so choose.
Sadly, and in stark contrast to the sharp increase in government spending during the Reagan period that spurred the recovery to the 1981 downturn, US politics during the Obama presidency have instead led to a cut-back in government spending, with a resulting drag on growth.  The disappointing consequences are clear.

Eurozone Unemployment at Record High: The Consequence of Austerity Programs

Eurozone Unemployment Rate, Dec 2007 to March 2013

As reported in the recent release from Eurostat, Eurozone unemployment rose again in March to a record 12.1%.  This is the highest rate ever for the Eurozone, and indeed the highest rate since at least 1983 (the earliest date for unemployment data reported by Eurostat) for the underlying countries.

Austerity programs do increase unemployment, despite what senior European officials have said.  On this, one might recall the famous assertion in June 2010 of Jean-Claude Trichet, then head of the European Central Bank, that austerity programs would be expansionary and lead to job creation.  As was discussed in an earlier post on this blog, in a June 2010 interview with La Repubblica (the largest circulation newspaper in Italy), Trichet said:

Trichet:  … As regards the economy, the idea that austerity measures could trigger stagnation is incorrect.

La Republicca:  Incorrect?

Trichet:  Yes …

And in an interview a month later in the newspaper Libération of France:

Libération:  Do the austerity plans announced amid monumental disarray by the Member States pose the risk of killing off the first green shoots of growth?

Trichet:  It is an error to think that fiscal austerity is a threat to growth and job creation. …

At the urging of Trichet, other European officials, and especially German government officials, most of Europe then began to reverse the stimulus programs of late 2008 and 2009  –  programs that had stopped and then reversed the free fall resulting from the 2008 economic and financial collapse.

Exactly one year after Trichet made his famous assertion, unemployment rates in the Eurozone began a steady upward march, which have continued ever since.