The Recovery And Its Discontents
This article is based on “ Destabilizing an Unstable Economy,” the recent issue of Strategic Analysis published by the Levy Economics Institute of Bard College, co-authored with Dimitri Papadimitriou and Gennaro Zezza.
The current situation in the United States presents a seeming paradox. On the one hand, the US economy is about to enter its eighth consecutive year of recovery, and in the first months of 2016, the unemployment rate fell below 5%, its lowest level since the beginning of the economic crisis of 2007–2009. On the other hand, there seems to be general discontent about the state of the economy. For example, according to various public opinion polls, the principal concern of voters in this year’s presidential primaries has been “economy/jobs”. This concern has been a main — if not, the main — factor behind upsets in both races.
However, if we look a little closer, the paradox resolves. Figure 1 depicts the path of real GDP from the trough to the peak of each post–World War II economic recovery, at quarterly frequency. Each line in the figure includes the trough of each business cycle — normalized to 100 — and the peak of the subsequent recovery. The three colored lines correspond to the three latest economic recoveries, including the current one; gray lines correspond to previous postwar recoveries. Two things stand out: First, the three most recent recoveries have been the slowest in US postwar history. Second, the current recovery is the weakest of them all.
The employment-to-population (E/P) ratio shown in Figure 2 yields the same pattern. Most important, at the end of 2015, the E/P ratio was still below where it was at the trough of the cycle. According to the latest data, not until April 2016 did the E/P ratio reach the level of the second quarter of 2009 — still more than three percentage points below its pre-crisis level.
Labor productivity growth has also been among the slowest of all postwar recoveries (Figure 3). Yet, without this slow increase in productivity, the number of jobs created would have been significantly lower. At the same time, this slow increase indicates that these are low-productivity and low-paid jobs.
Taken together, Figures 1, 2, and 3 give some clues about the aforementioned paradox. We can better understand the reasons behind the current slow recovery if we go one step further and decompose GDP into its main components:
GDP = Consumption + Investment + Government Expenditure + Exports – Imports
This decomposition points to three main structural problems for the US economy: (1) high income inequality, (2) fiscal conservatism, and (3) high external deficits. These problems explain the secular decline of the dynamism of the US economy over the past three decades, the Great Recession of 2007–2009, and the “stagnant recovery” of the past seven years.
The problem of income inequality has been well documented, for example, in Capital in the Twenty-First Century by Thomas Piketty and Inequality and Instability by James Galbraith. Since the early 1980s, there has been an enormous redistribution of income toward the top, where household incomes have soared. By contrast, incomes for the rest of the population (the 90% or the 99%) have stagnated. For example, according to data from the World Wealth and Income Database, the real average pre-tax income of households at the bottom 90% of the distribution was lower in 2014 than it was four decades ago. In effect, the majority of households gained very little — if anything — from the growth in the US economy over that period. This fact is probably the most important reason behind the generalized discontent.
From a macroeconomic point of view, the increase in inequality implied the transfer of income shares from those whose propensity to consume is very high (middle-class and lower-income households) to those whose propensity to consume is much lower (top-income households). As a result — other things being equal — consumption tends to decrease.
The pressures that increasing income inequality put on consumption can be seen in Figure 4. Not surprisingly, because consumption is the largest part of GDP, the pattern is similar to that in Figure 1. Although the weaker performance of consumption has been visible since the 1990s, the negative impact of widening inequality was contained through increasing indebtedness; households at the bottom maintained their relative living standards by assuming more and more debt. As a result, the debt-to-income ratio of households in the bottom 90% more than doubled in the three decades leading up to the crisis. These high levels of indebtedness are another drag on the present recovery of consumption, as households try to reduce their debt levels.
An increase in income inequality does not always lead to a slowdown in the growth rate of an economy. Besides, within a capitalist economy, profitability sets the tone: an increase in inequality can lead to higher profitability, more investment, and higher growth. The rationale of “trickle-down” economics, which has been hegemonic in US politics since the time of Ronald Reagan, is a (vulgar) variant of this argument. Let the market determine distribution, profitability will increase, and thus investment will boom and jobs will be created — the profits will “trickle down” and everybody will benefit.
As Figure 5 shows, this predicted investment boom has not been the case, at least not in the most recent recoveries. Although the break is not as clear as in the case of consumption, investment growth in the past three cycles has been on the low side of postwar recoveries. The 2001–2007 recovery in investment was by far the slowest, and the current recovery is the second slowest. The picture would be worse if we compared the cycles from peak to peak. It was not until the first quarter of 2015 that real investment reached its pre-crisis peak.
The second structural problem of the US economy, fiscal conservatism, is related to another aspect of “trickle-down” ideology: an aversion to government interference in the economy. Over the past three-and-a-half decades, there has been a systematic effort to limit government spending. Fiscal conservatism was introduced in the 1980s, but was first implemented in the 1990s, with 2000 as the only year in the whole postwar period when the general government — federal, state, and local — was a net lender. It has reached its apogee during the current recovery, the only postwar recovery in which real government expenditure has decreased (Figure 6). This is the other major drag on aggregate demand that is slowing down the recovery.
Fiscal consolidation is pervasive both in terms of the level of the government and the types of expenditure that are being curtailed. Though budget cuts at the federal level have received the most attention, local and state governments also play important roles. This has been the only recovery in which government spending at the local and state levels has decreased. At the same time, expenditure cuts include almost every type of government spending, including those favored by proponents of supply-side economics, such as expenditure for public infrastructure or research and development.
To complete the examination of the expenditure components of GDP also requires a look at the foreign sector: exports and imports. Figure 7 shows that exports performed strongly at the beginning of the current recovery but have slowed down a lot recently, mostly because of the appreciation of the US dollar and the slowdown in the economies of US trading partners. As a result, and despite the strong start, the recovery of exports has also been the slowest in the postwar period, putting another drag on aggregate demand and the recovery.
Figure 8 shows that the recovery of imports has also been the slowest in the postwar period. Note that imports exert a negative impact on GDP, so other things being equal, the slower the recovery of imports, the faster the recovery of GDP. This slow growth of imports is not surprising, given the slow recovery of GDP.
At the same time, another factor played a major role: the new methods of extracting oil and gas (i.e., hydraulic fracturing or “fracking”), which led to a significant reduction in petroleum imports. The result was a near halt in the increase of total real imports over the 2011–2013 period. Figure 9 provides a better idea of the importance of this development: beginning in the early 1990s and until the recent crisis, there was a very big increase in the US trade deficit, from a little more than zero in 1992 to close to 6% of GDP in 2007. This large trade deficit, which is the third important structural problem of the US economy, was caused by the successful invasion of US markets by foreign competitors and the outsourcing of a lot of manufacturing activity — facilitated to a large extent by the free-trade agreements of the time.
The trade deficit decreased sharply during the most recent crisis and then started to increase again when the recovery began in 2009, following the same pattern of previous recoveries. Indeed, as Figure 9 shows, the trade deficit of goods except petroleum has followed its pre-crisis patterns and at 4% is now close to its pre-crisis peak. The major change has come from the trade deficit in petroleum and related products, which followed its pre-crisis pattern in the first two years of the recovery but then changed course and decreased to almost zero at the end of 2015.
It is hard to exaggerate the importance of this development. Had the trade deficit of petroleum products kept increasing along its pre-2011 trend, it would now be more than 3% of GDP. In that case, the overall trade deficit would have exceeded its pre-crisis peak. From a purely macroeconomic point of view, and if we ignore the environmental repercussions (which is not what I suggest we should do), this decrease in the trade deficit of petroleum products has been the only important structural change compared to the pre-crisis period. This is important to keep in mind to understand the political economy of drilling.
In summary, the discussion above identifies three major structural problems for the US economy: (1) high income inequality, (2) pervasive fiscal conservatism, and (3) high external deficits. These structural problems led to the 2007–2009 crisis. Given high external deficits and fiscal conservatism, growth in aggregate demand and jobs could come only as a result of decreased savings and increased indebtedness in the private sector — especially households. This process of debt-driven growth could be sustained only as long as it was facilitated by asset bubbles (in the stock and real estate markets), but eventually, such growth proved unsustainable.
High income inequality exacerbated this problem by putting another heavy drag on aggregate demand. Further compounding the problem, the increase in indebtedness of the household sector fell largely on households at the bottom of the income distribution. In other words, given these three structural problems, growth and jobs can come only as a result of an unsustainable increase in the indebtedness of households — especially those at the bottom of the distribution. The other alternative is the situation of the past seven years: in the absence of increasing indebtedness, the economy stagnates.
Therefore, achieving sustainable economic growth in the United States requires, first and foremost, addressing these fundamental structural issues: (1) decrease in income inequality, (2) improvement in the US external balance, and (3) relaxation of the government’s fiscal stance. The alternative is a future of secular stagnation or debt-driven recoveries that will result in increasingly severe financial and economic crises. Under such circumstances, discontent can only increase.