Consider the dominant story that economic forecasters have been telling you for years now: The U.S. economy just can’t catch a break. It has been poised time and again to rocket back to a growth rate that would recapture all the ground lost in the Great Recession, while delivering big job gains. But every time, some outside event scuttles things. The euro crisis flares up. A Japanese tsunami scrambles global supply chains. Lawmakers play chicken with the federal debt limit.
Most recently, “fiscal cliff” tax hikes and sequestration budget cuts are playing the culprit. And the bad-luck economy, like a fireball pitching prospect dogged by freak arm injuries, never reaches its full potential.
Now consider the possibility that the can’t-catch-a-break story gets it backward. What if the economy isn’t particularly unlucky? What if it’s basically doing what we should expect it to? What if something has changed, thanks to fallout from the recession, or a string of bad policy choices, or both, and growth has shifted into a lower gear? What if this slow and fragile expansion is as good as we’re likely to get for a while?
This is an alternative story that economists across the ideological spectrum have begun to explore. If it’s correct, the implications for economic policy are big.
First, let’s review some facts. The U.S. economy grew by 2.2 percent last year, 1.8 percent the year before, and 2.4 percent in 2010. That was not enough growth to bring down unemployment speedily, which is why — three and a half years after the recession officially ended — 12 million Americans are still looking for work.
Growth has also consistently fallen short of forecasters’ expectations. At the end of 2009, for example, economists at the Federal Reserve projected the economy would grow by 2.5 percent to 3.5 percent in 2010. In 2011, they said growth would be 3.4 to 4.5 percent; in 2012, they said 3.5 to 4.8 percent. Each year, actual growth fell short of the lower number in the range. And each year, the Fed adjusted and predicted that faster growth was right around the corner. This isn’t to pick on Chairman Ben S. Bernanke’s crew — economists were similarly over-optimistic at the Congressional Budget Office and in several large Wall Street research divisions.
Where our stories diverge is on the reasons those forecasts were wrong.
Here’s the standard explanation, from a sharp economist named David E. Altig, the executive vice president and director of research at the Federal Reserve Bank of Atlanta. Altig says the economy would have grown faster if a bunch of unanticipated problems — most notably the European financial crisis, in all its iterations, and the now-frequent instances of fiscal brinkmanship in Washington — hadn’t popped up to rattle consumers and business executives.
This is how many Fed and CBO economists view the past few years, and why they remain so optimistic that faster growth is just around the corner. (CBO projects the economy will grow by 3.5 percent next year; the Fed predicts between 3 and 3.5 percent.) History explains their thinking: In past recessions, the economy has lost ground, only to roar ahead in later years to return to its historical growth trends. It’s sort of like a pro cyclist sprinting to catch up with the field after blowing a tire in a road race.
“It’s still the story of the unlucky shocks” and of growth eventually bouncing back to make up its lost output, Altig says. He adds: “We’re keeping hope alive with our forecast.”
‘The new malaise’
For the gloomy story, meet Kevin Warsh, a former Fed governor and economic adviser to President George W. Bush. Warsh is now a distinguished visiting fellow at Stanford University’s Hoover Institution, where he has developed a pessimistic theory about the economy. He calls it “the new malaise.”
It goes like this: U.S. policymakers have tried for several years to splash gasoline on the flames of growth in hopes of stoking a bonfire. They’ve thrown in the $800 billion of tax cuts and spending increases contained in the 2009 economic stimulus bill, as well as the extraordinary measures the Fed has taken in an attempt to boost employment: holding short-term interest rates near zero for years and buying an unprecedented amount of long-term securities such as Treasury bonds in order to push down long-term interest rates. Warsh’s story is that those efforts didn’t work, and to make matters worse, they dampened the economy’s longer-run growth prospects.
“The conventional wisdom has it that the U.S. economy has been hit by a lot of bad luck at this point,” he says. “My view is simpler. These bad breaks happen when the global economy is weak and underperforming, and financial markets have been heavily influenced by government policy and decisions. That breeds bad luck.”
The reason the economy has been underperforming, Warsh says, is that policymakers responded poorly to the financial crisis. They focused on short-term growth boosts and neglected what you might call basic economic infrastructure investments. They didn’t open big new markets for international trade in order to expand exports, and they didn’t streamline the tax code to promote investment.
Meanwhile, Warsh said, lawmakers added new regulations to the financial system that solidified an oligopoly at the top of the banking industry, one that has served to restrict the flow of credit to small businesses and entrepreneurs. The Fed’s easy-money policies, he adds, have padded corporate profits but haven’t “trickled down” — his words — to average Americans.
Slow growth is the consequence of those policies, Warsh says. He fears the consequence of prolonged slow growth is a drop in the economy’s potential to grow. Longtime unemployed workers have lost skills, making it harder for them to find work. Executives have lost confidence in the economy’s ability to expand and willingness to invest in it. “We’ve been in this period of the new malaise for so long that workers and companies have lowered their expectations for what the U.S. economy can do,” Warsh says.
If that’s the case, it’s as if our fireball pitcher has undergone arm surgery, and instead of throwing 95-mph fastballs, he’s stuck at 85 mph. Warsh says an infusion of better, long-run-focused policies is the only way to bring that velocity back — a second surgery of sorts.
Warsh concedes that there isn’t a lot of data to back up his case. Researchers have found some, but not much, evidence of skill erosion affecting the unemployment rate. Economists are only starting to quantify the effects of diminished confidence, or the equally elusive “policy uncertainty,” on growth. To this, Warsh likes to quote one of his mentors, the great free-market economist Milton Friedman: “Milton used to say, ‘everything we know in economics we teach in Econ 1, and everything else is made up.’ ”
You can tell an inverted version of Warsh’s story through the economic models of another famous economist, John Maynard Keynes. That story holds, like Warsh’s story, that policymakers fumbled the response to the recession — but in this telling, the problem is that they didn’t do enough. The depth of the recession was so great, the effects of the financial crisis so dire, that the economy needed a huge dose of fiscal and monetary stimulus to regain all the lost ground and return to historical growth trends.
Since the stimulus that policymakers supplied wasn’t big enough, the economy hasn’t grown as fast as it could have, the Keynesian story goes. Janet Yellen, the vice chair of the Fed, gave voice to that story in a February speech. After boosting the economy in the first year after the recession, she said, fiscal policy “has actually acted to restrain the recovery. State and local governments were cutting spending and, in some cases, raising taxes for much of this period to deal with revenue shortfalls. At the federal level, policymakers have reduced purchases of goods and services, allowed stimulus-related spending to decline and have put in place further policy actions to reduce deficits.”
The result of those policies, per Yellen’s critique, is that growth has remained slower than it could have been if the stimulus had been more . . . stimulative. The long-term danger is the same one Warsh warns about: workers and companies lowering expectations for growth.
Both the Warsh story and the Keynesian story lead to the same slow-growth conclusion, given the current path of economic policy. No one expects Congress and President Obama to pass more fiscal stimulus anytime soon. The sorts of changes Warsh favors — including big new trade pacts, broad-based tax reform to simplify the code and a bill to open the door to new waves of immigrants — don’t appear to be right over the horizon, either. And if years and years of subpar growth really do render millions of workers effectively unemployable, policymakers would need to worry a lot more about designing new and targeted skills-training programs, much better than the ones currently in place.
An in-between scenario
This brings us to a third story, which lies somewhere between the happy and pessimistic camps. It says that some things have changed in the economy and our growth prospects have fallen a bit, but not by enough to cloud out all hope for a faster recovery anytime soon.
Two ideas are central to this story. First is that the recession didn’t just dig a big hole for the economy to climb out of, it also messed with the ladder. This is the basic theory set forth by the economists Carmen Reinhart and Kenneth Rogoff in their book “This Time is Different”: Financial crises weaken the financial system, slowing growth for years until the system heals.
Second, it’s possible economists were tricked by the overbuilding of the mid-2000s into thinking the economy had a higher growth ceiling than it actually does. (Housing bubble is to economy, in this scenario, as steroids would be to our fireballer.) “If you believed that we were in a housing bubble, and that there was this construction that was going on that far exceeded what we should have been, the notion that we were above potential is not that far-fetched,” says Michael T. Owyang, an economist at the St. Louis Fed.
That’s consistent with the findings of two Cleveland Fed economists, Margaret Jacobson and Filippo Occhino, who wrote in a recent research note that a decline in investment is the big reason the economy’s potential appears to have fallen. Occhino says that decline represents the aftershocks of too much pre-crisis residential and non-residential construction. But most importantly, he says those aftershocks won’t stop the economy from eventually climbing back toward the growth it was on track for before the recession, especially if policymakers stop stepping on growth with ill-timed tax hikes and budget cuts.
Still, many economists, even the ones holding to the “bad luck” story, agree that something has changed in the economy post-recovery; our fireballer, they say, appears to have lost some speed on his fastball permanently. The easiest way to see that is in prices. If there was still a huge “void” of demand in the economy, says Altig of the Atlanta Fed, we’d see them falling across the board. Prices aren’t rising very fast, even with aggressive monetary easing, but the fact that they aren’t falling probably suggests the demand void — the untapped potential in the economy — isn’t as big as forecasters once thought.
This has prompted some wondering aloud, and it has given rise to perhaps the most interesting new story you hear from economists: Um, there’s a lot we don’t know about the economy. All sorts of changes are disrupting the traditional forecasting models. Baby boomers are leaving the labor force; the rate of women entering it has plateaued. New technologies are changing how we think about work. One big story of the next few years will be how much all of this changes economists’ predictions.
When you miss so regularly on your forecasts, Altig says, “it’s easy to think we have to rethink everything we think we know.” But, he adds, “You can be wrong for a very long period of time and still have the underlying structure and story about the economy correct. That’s not crazy. I guess that’s where I would be right now. It’s not like you have to throw out how you think about these things. You just have to have the same humility you always have.”
Heroes forced to humility by uncertainty, in a world that defies easy explanation. Sounds like a good novel, right?