Why Has The Recovery Been So Sluggish?

Written by William C. Dudley
on November 16, 2012 No Comments
Categories : Word On The Street

12761_william_c._dudley Why Has The Recovery Been So Sluggish? WORD ON THE STREET: Why has the U.S. recovery been so sluggish and consistently weaker than expected? U.S. economic growth has been quite sluggish in recent years. For example, annualized real GDP (gross domestic product) growth has averaged only about 2.2% since the end of the recession in 2009. As a consequence, we have seen only modest improvement in the U.S. labor market.

Not only has growth been slow, but it has also been disappointing relative to the forecasters' expectations. For example, the Blue Chip Consensus has been persistently too optimistic in recent years.

Forecasters have consistently expected the U.S. economy to gather momentum over time. With only one exception, the growth forecasts for each year have been revised downward over time, as the expected strengthening did not materialize.

Sometimes, inflation has been a bit higher than expected, other times a bit lower. On balance, inflation has been very close to our 2% longer-run objective.

In my view, the primary reason for the poor performance of the U.S. economy over this period has been inadequate aggregate demand. There are several explanations for this. Although some were well known earlier, others have only become more obvious as the recovery has unfolded.

One reason is the nature of economic recoveries following financial crises. On that basis, the poor performance of the U.S. economy is not unusual – historical experience shows clearly that recoveries following financial crises typically are very slow and difficult.

During the credit boom, finance is available on easy terms and the economy builds up excesses in terms of leverage and risk-taking. When the bust arrives, credit availability drops sharply and financial deleveraging occurs. Wealth falls sharply, precautionary liquidity demands increase and desired leverage drops further. In the U.S. case, there were some idiosyncratic elements, such as subprime lending and collateralized debt obligations. But, in the end, the U.S. experience included the major elements of most booms: Too much leverage, too little understanding of risk, too easy credit terms, and then a very sharp reversal.

When the bust arrives, over-indebted households and businesses want to increase their saving and liquidity buffers, and financial intermediaries want to raise credit standards. Both responses restrain demand and make a cyclical rebound more difficult. In the U.S. case, because the bust was concentrated in housing, the scope for a strong cyclical recovery was particularly constrained because the interest-rate sensitive sector that would typically lead such a rebound could not recover until the overhang of unsold homes and the impairment of housing finances was corrected.

The U.S. recovery has also been subpar because it has been taking place in the context of a weak global economy. Historically, after a country experienced a financial crisis, growing foreign demand and currency depreciation have often led to a sharp improvement in the trade account that has put a floor under economic activity. In such circumstances, rising exports substitute for domestic consumption in supporting aggregate demand.

This demand, in turn, encourages businesses to hire and invest. In contrast, this time the shock generated by the U.S. housing bust had global consequences, exposing economic vulnerabilities outside of the United States, especially in Europe. Under these circumstances, the scope for trade as a support for U.S. growth, while positive, has been very limited.

These two factors – the dynamics following financial crises and the weakness of foreign demand – help explain why U.S. growth has been weak, but I don't think these factors explain why it has been consistently weaker than expected.

After all, on the other side of the ledger, the policy response following the crisis has been much more aggressive than is typical. On the monetary policy side, the Federal Reserve cut short-term interest rates close to zero, communicated that short-term rates were likely to stay exceptionally low far into the future and undertook a series of large-scale asset purchases in order to ease financial conditions further.

On the fiscal side, in 2009, the Congress and administration enacted the largest fiscal stimulus program in history. Some of these fiscal actions were renewed (e.g., extended unemployment compensation benefits), and new initiatives were undertaken (e.g., the payroll tax holiday) once it became clear that the recovery was faltering. Also, there were significant policy actions taken to strengthen the banking system, including forcing banks to recapitalize so that they would have the capacity to sustain their lending.

So why has the recovery disappointed? One possibility is that the negative dynamics of a post-bubble environment are even more potent than had been appreciated. Feedback loops may be more powerful and frictions may be larger.

In the U.S. case, this is particularly germane with respect to housing and mortgage finance. For example, we have found significant shortcomings in those institutional structures available to support the workout of the overhang of mortgage debt in an efficient and timely manner.Â

A second reason may be the series of additional negative shocks experienced since the initial phase of the financial crisis. The largest of these relate to the crisis in the Eurozone. But one could also add the periodic commodity price shocks, the disruptive impact of the tragic Japanese earthquake and tsunami on global trade and production, and the effect of the uncertainties around the impending fiscal cliff on hiring and investing.

That said, the shocks since the acute phase of the crisis in the U.S. were not uniformly negative. Take, for example, the sharp increase in U.S. oil and natural gas production stemming, in part, from the innovations in drilling and extraction technologies. Not only does this rising production directly boost real GDP, but also the large drop in natural gas prices has significantly improved the industrial competitiveness of U.S.-based businesses.

A third reason for the weaker than expected recovery likely lies in the interplay between secular and cyclical factors. In particular, I believe that demographic factors have played a role in restraining the recovery. The developed world's populations are aging rapidly. In the U.S., for example, the baby boom generation, which is a particularly large cohort, is now beginning to retire. As the population ages, this has two consequences.

First, the spending decisions of the older age cohorts are less likely to be easily stimulated by monetary policy. That is because such age groups tend to spend less of their incomes on consumer durables and housing. Second, as the population ages and the number of retirees climbs, the costs associated with Social Security, government pensions and healthcare retirement benefits increase. This creates budgetary pressure and leads to a choice of raising revenue to fund these costs, cutting other government programs or cutting benefits.

Now if this all had been fully anticipated by retirees and near-retirees, then this would already be factored into their spending and saving decisions. But, I doubt that this has been the case. I suspect that many have been surprised by the swift change in economic circumstances as the housing boom went bust.

I doubt that many fully anticipated the budget crunch and the prospect that their future retiree and healthcare benefits would likely be curbed or their taxes would have to rise in the future. When households begin to anticipate this, they reduce their assessment of their sustainable living standards. This downward reassessment then feeds back to current spending and saving decisions.

Kind of a drag

A fourth reason why the recovery has been slower than expected may be that we overestimated the capacity for fiscal policy to continue to provide support to growth until a vigorous recovery was achieved. On the fiscal side, the authorities can cut taxes or increase spending to support income and demand during the deleveraging phase that follows the financial crisis. But the ability of such stimulus to continue to support economic activity ultimately encounters budgetary limits.

For example, the need to keep the long-term fiscal trajectory on a sustainable path limits the size and duration of federal fiscal stimulus measures. For state and local governments, the statutory requirements for balanced budgets meant that fiscal policies turned restrictive relatively quickly once budget surpluses and rainy day funds were exhausted, and this was only temporarily mitigated by federal transfers to the states as part of the initial fiscal stimulus program.Â

Fiscal policy is now a drag rather than a support to growth in the U.S., and this will likely continue.Â

William C. Dudley is president and CEO of the Federal Reserve Bank of New York. This article is adapted and edited from remarks made at the recent annual meeting of the National Association for Business Economics. The original text is available online.

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