High and Dry

The Economic Recovery Fails to Deliver

John Miller

This article is from the March/April 2004 issue of Dollars and Sense: The Magazine of Economic Justice available at http://www.dollarsandsense.org

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This article is from the March/April 2004 issue of Dollars & Sense magazine.

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This economy is pumped. Boosted by economic stimulants—military spending, tax rebates, interest rate cuts, and a spate of mortgage refinancing—the U.S. economy expanded at an 8.2% annual rate in the third quarter of 2003, its fastest pace in nearly two decades, and at a respectable 4% rate in the fourth quarter. The Dow is back over 10,000. Corporate profits are up. Business investment is improving, and consumer confidence is holding.

Predictably, the Wall Street Journal's editors spent the winter holidays chortling about "the merry economy." The 55 blue-chip economists the Journal surveyed predict that economic growth will exceed 4% and that the economy will create 1.5 million jobs this year, just in time for George W. Bush's election campaign.

But despite this ginned-up sense of economic well-being, the specter of stagnation—that the United States could go the way of Japan and sink into a decade-long economic funk—continues to haunt the U.S. economy.

The current wave of frenetic economic activity has done nothing to solve the underlying flaws of the post-bubble economy. Overcapacity, especially the hangover from the collapse of manufacturing and the dot-coms, oppressive consumer debt burdens, an ever-widening trade deficit, burgeoning budget deficits, and unprecedented inequality—all are still with us. And even after a heavy dose of economic stimulants, job creation in this recovery remains the worst on record.

The Bush administration has expended a lot of fiscal firepower to stimulate this recovery. But the administration's stimulants of choice are not generating a cumulative and self-sustaining economic expansion. What's more, the prescription on many of them is about to expire. Future tax cuts will go ever more exclusively to the well-to-do, resulting in less new consumer spending. The Fed has little room left to cut short-term interest rates further. Higher long-term rates have already slowed mortgage refinancing. And that is to say nothing of the toxic side effects of the Bush team's economic antidepressants: they gut public-sector social spending and support an economic growth that does surprisingly little to improve the living standard of most people.

Eight Months Down, Three Years Sideways

Last July, the National Bureau of Economic Research (NBER)—the nation's official arbiter of the business cycle—declared that the recession that began in March 2001 had ended way back in November of that year, only eight months later. The 2001 recession was neither long nor deep. The average duration of post-World War II recessions is 11 months. And the output lost in the 2001 recession, measured by the decline in real Gross Domestic Product (GDP, the broadest single measure of economic output), was less than a third of the drop-off during the 1990-91 recession.

Why did it take the NBER's economists 20 months to recognize a recovery that was already underway? Because this recovery has been so weak that the NBER hesitated to declare the recession over. The economy fell for just eight months but it has crawled sideways for nearly three years. Real personal income (income of households adjusted for inflation) has grown much more slowly than in past recoveries, and the economy has continued to lose jobs long after a typical recovery would have returned to pre-recession job numbers.

Instead of a robust recovery, the economy has entered "a twilight zone—growing fast enough to avoid an official recession but not fast enough to create jobs," according to Paul Krugman, economist and New York Times columnist. Economic growth averaged just 2.6% from the official end of the recession in November 2001 through the second quarter of 2003. Economic journalist William Greider warned the U.S. economy was flirting with something far worse, "a low-grade depression." (See "The Japan Syndrome," sidebar.)

Running on Fumes

At this January's World Economic Summit in Davos, Switzerland, Stephen Roach, chief economist at Morgan Stanley investment bank in New York, warned business leaders that "the main engine of the global economy, the … U.S., is right now running on fumes." Tax cuts, home sales and mortgage refinancing fueled by low interest rates, and Iraq-driven military spending—not self-sustaining job and wage growth—fueled the 2003 growth spurt. Each of those additives to the economic fuel tank will be less able to power future economic growth, either because it's now in short supply or because it has gummed up the economic engine.

Take monetary policy. Interest rate cuts were key to keeping the weak, post-bubble economy out of a deep recession: they helped underwrite last year's surge in consumer spending on durable goods, especially housing and automobiles.

But the Fed will be hard pressed to coax more spending out of the economy. With the federal funds rate at 1%, there is not much room left for further rate cuts. In addition, interest rates on home mortgages are already rising. This will slow the spate of mortgage refinancing that put money in consumers' pockets in 2002 and 2003: over the last two years, half of all U.S. homeowners refinanced $4.5 trillion in mortgage debt.

On top of that, consumers are up to their eyeballs in debt. Debt service now claims a record 13% of disposable income, despite the interest rate cuts. Three years of a bear market has put a real dent in people's net worth, and less mortgage refinancing will do nothing good for the value of their homes. With employment lower than three years ago and wages stagnant, consumers sooner or later will stop spending, as Roach warns. In fact, by the end of last year the surge in consumer spending, especially for automobiles, had already cooled.

Fed interest rate cuts never bolstered investment spending as much as consumer spending. Lingering excess productive capacity across the economy left businesses reluctant to make new investments. During much of the recovery, corporations have used the lower interest rates to pay down short-term debt and to buy back their own stock, not to add to capital spending.

Business investment did pick up considerably in the second half of 2003, posting its strongest gains since the first quarter of 2000. Robert Shapiro, economist with the centrist Progressive Policy Institute, says that "with consumer spending slowing, improved business fixed investment is now the strongest private sector support for the expansion in 2004." But even with the recent upswing in corporate spending, investment levels are quite modest. During the red-hot third quarter of last year, real business investment, as Shapiro himself emphasizes, was still 7% lower than it was in 2000 and even below its average level during the 2001 recession.

Fed interest-rate cuts were also supposed to fix another obstacle to sustained economic growth and job creation: the gaping U.S. trade deficit. But the fix hasn't worked too well.

Fiscal Policy Misses the Mark

Fiscal policy, the manipulation of government spending and taxing policies, is just as problematic for sustaining economic growth as monetary policy. For the Bush administration, fiscal policy usually means just one thing: cutting taxes for the well-to-do. Three rounds of tax cuts for the rich, combined with last year's military spending for the Iraq war and its aftermath, have indeed shifted the government's fiscal status in a big way: the federal budget went from a $236 billion surplus in fiscal year 2000 to a $521 billion projected deficit in fiscal year 2004.

Such a powerful fiscal swing, the equivalent of about 7% of GDP, was sure to lift economic growth over the short term, almost regardless of the particulars. And Bush fiscal policy did goose economic growth rates in 2003. When the invasion of Iraq gave rise to the biggest quarterly increase in military spending since the Korean War, GDP growth rates during the second quarter picked up from 2.0% to 3.1%, with economic analysts attributing three-quarters of the spike to government spending. Similarly, tax rebates over the summer added to the consumer spending that drove the third quarter GDP growth spurt.

But the limitations of the Bush team's attempt to punch up a sluggish economy for the election year have already begun to show. First off, future tax cuts will do less to add to consumer spending because they go ever more exclusively to the well-to-do, who spend a smaller share of their income than other taxpayers. Even in 2003, nearly one-half of taxpayers (49%) got $100 or less back in lower taxes, reports Citizens for Tax Justice. In 2005, that number rises to three-quarters of taxpayers, and it continues up from there. At the same time, nearly two-fifths of the Bush tax cut goes the richest 1%.

Second, the Bush stimulus package has done little or nothing to relieve the pressure on state and local budgets. With 30 states still facing between $39 and $41 billion in budget shortfalls in fiscal year 2005—the equivalent of 8% of their expenditures—more cutbacks in state spending are inevitable. Those state budget cuts are sapping the stimulative effect of any federal deficit spending. Nicholas Johnson, director of the State Fiscal Project at the Center on Budget and Policy Priorities, estimates that the state fiscal crisis is "taking at least half a percentage point out of the growth rate of the national economy."

The administration's failure to address the budget crisis in the states is not only trimming economic growth, it's also destroying critical programs. State budget cuts have hit working people and the poor especially hard. The federal government has shifted responsibility for social spending onto the states, and that is what's being cut. California, for instance, cut spending by $12 billion in the two years prior to last fall's recall election; schools there now go without computers, and public libraries are unable to purchase books. Nationwide, 34 states have cut programs such as Medicaid and the Children's Health Insurance Program that provide health care to low- and moderate-income families.

And while fiscal stimulus might be pumping up measured growth rates, the Bush administration is running large deficits likely to be sustained even if investment spending continues to improve and labor markets eventually tighten. Those long-term structural deficits, as economists call them, could provide the political justification for further cutbacks in social and infrastructure spending necessary to put economic growth on a more solid footing. In fact, if the Bush tax cuts are made permanent, there would be no room in the federal budget for any domestic discretionary spending in just eight years, according to a recent study by Eugene Steuerle, a senior fellow at the Urban Institute. By 2012, entitlements (Social Security, Medicare, and Medicaid), military spending, and interest on the growing government debt would have absorbed all remaining federal revenues, leaving not a dollar for education, job training, housing, environment, community development, energy, public infrastructure, or other domestic programs. That would be a disaster not only for working families and children, as the Urban Institute emphasizes, but for the productivity of the U.S. economy as well.

Jobless Recovery to Job-Loss Recovery

Whatever administration and Fed policies have done to produce an uptick in measured economic growth, they have done little to create jobs—the key to sustaining wage growth and a self-perpetuating economic expansion. And the Bush administration sure did promise new jobs. With the 2003 tax cut in place, the president's Council of Economic Advisors insisted, the economy would create 306,000 jobs a month from July 2003 to December 2004.

Hardly. When economic growth picked up in the final five months of 2003, the recovery finally stopped losing jobs. But the economy added a total of just 278,000 new jobs in those five months, with 80% of those job gains concentrated in temporary staffing, education, health care, and government. That is fewer jobs than the Bush team's promised monthly total.

Job creation in this recovery does not fall short just with respect to the administration's inflated promises, but by any reasonable measure. Even with those new jobs in the last five months of the year, the economy lost a net 331,000 jobs for 2003, on top of 1.5 million lost in 2002. The last time payroll employment declined for two consecutive years was in 1944 and 1945, as war production wound down. And that is a far cry from the average 300,000 new jobs per month the U.S. economy posted from 1995 to 2000.

The Japan Syndrome: Could It Happen Here?

It isn't only left-leaning journalists sounding the alarm bells. Even the Wall Street Journal asked, "Is the U.S. economy at risk of emulating Japan's long swoon?"

During the 1980s, Japan enjoyed an economic boom as heady as the one the United States saw in the 1990s, complete with a soaring stock market and a red-hot housing market. But when the bubble burst, the Japanese economy sank into a decade-long economic slump. Japanese income growth slowed, falling behind the United States'. The Nikkei, Japan's major stock market index, lost three-quarters of its value from its peak in 1989. The Japanese real estate boom collapsed in 1991; in 2003 a house in Tokyo cost less than half of what it did in 1991. A tanking real estate sector and a slowing economy saddled Japanese banks with bad loans. Excess capacity, especially high for Japanese automakers, discouraged new investment and ensured that the slowdown would persist.

The 1990s boom in the United States came to a similar if less severe end. By 2000, the U.S. stock market bubble had burst. Broad measures of stock values lost about one-third of their peak values over the next two years. Manufacturing had already hit the skids. Industrial production fell steadily, contributing to a general excess of industrial capacity. Today, capacity utilization rates still hover at about 75%, and the manufacturing sector has shed jobs for some 42 straight months. The new economy fared no better. The NASDAQ, the high-tech stock index, melted down, losing nearly three-quarters of its value from March 2000 to July 2002, and gaggles of dot-com firms folded, putting plenty of white-collar workers out of work.

Only the continued strength of the U.S. real estate market, along with the willingness of debt-strapped U.S. consumers to spend, seemed to stand between the U.S. economy and Japan's fate. The Fed would add one more factor that insulated the U.S. economy against a Japan-style economic collapse: monetary policy. Ironically, it was the Fed's own repeated interest rate hikes in the second half of 1999 and the first half of 2000, along with the Clinton administration's downsizing of the federal government, that contributed mightily to bringing on the economic slowdown in the first place.

In the summer of 2002, the Fed devoted its annual retreat in Jackson Hole, Wyoming, to the threat of Japanese-style stagnation. Fed members and their boosters ended up assuring themselves that they had averted the threat by acting more quickly than Japanese central bankers had. While the Japanese central bank (CBJ) had waited nearly two years after the bubble burst to act, it then set about furiously cutting short-term interest rates, from 6% in 1991 to under 1% in 1995. The Fed did act more quickly than its Japanese counterpart, dropping the federal funds rate on overnight loans to commercial banks from 6.25% to 1.25% in just two years.

Has the Fed saved the day? That the U.S economy has muddled through the last three years with slow growth and is now in the midst of a growth spurt is enough for many to conclude that the threat of stagnation is behind us. But that would be a mistake. Japan's economy did not collapse into stagnation but slid gradually, as the Japanese bankers attending the Jackson Hole retreat emphasized. At the same time, economic forecasters repeatedly predicted that Japanese economic growth rates would soon pick up. Most ominously, Japan's real estate bubble burst a couple of years after its stock market bubble. If the housing market does fall apart, U.S. banks could end up in critical condition much as they did during the mid-1980s banking crisis that gripped much of the nation. And with U.S interest rates already close to zero, Pam Woodall, economics editor of the conservative British weekly the Economist, worries that "a housing bust might therefore nudge the economy into deflation."

Since the recession began 33 months ago, 2.4 million U.S. jobs have disappeared. Following every other post-World War II recession, jobs had fully recovered to their pre-recession levels within 31 months of the start of the recession. Worse yet, as a recent study by economists at the New York Federal Reserve Bank shows, a far larger share of recent layoffs have been permanent, rather than the temporary cyclical layoffs dominant in most previous recessions.

The current recovery can't even stack up to the only other "jobless" recovery on record, the 1991-92 recovery that cost Bush's father re-election. Business Week calculates that to equal the job creation record of the early 1990s rebound, the economy would need to have added 3 million more private sector jobs by now, including 1,547,000 more manufacturing jobs and 707,000 more information technology jobs.

Jesse Jackson warned the 2000 Democratic Convention to "Stay out of the Bushes"—advice that should be taken seriously by anyone concerned with holding onto a job or finding a new one. We have gone from a jobless recovery under the elder Bush to a job-loss recovery under the younger Bush.

Employers are unwilling to add new jobs because they remain unconvinced that the economic recovery is sustainable. Instead of hiring new workers, bosses are squeezing more out of the old ones. This, along with corporate restructuring and layoffs, has produced rapid increases in productivity—the economy's output per hour of labor input. For instance, during the last two years, the hourly output of U.S. workers has gone up at a 5.3% pace, exceeding the "new economy" productivity growth rate of 2.6% from 1996 to 2001. For the first time in a postwar recovery, productivity is growing far faster than the economy.

Manufacturing has been especially devastated. Factory productivity has gone up by 15%, versus a 9% rise in the comparable period in the early 1990s. That has helped produce the longest string of manufacturing layoffs since the Great Depression. Ohio, Michigan, and Pennsylvania have each lost 200,000 or more manufacturing jobs since January 2001.

Another drain on U.S. job creation is the increasing number of jobs lost to global outsourcing. Not only manufacturing jobs are going abroad, but also white collar work, from backroom office operations (bookkeeping, customer service, and marketing) to engineering and computer software design. Increased competition engendered by the Internet has allowed formerly non-tradable jobs to escape abroad, in this latest bout of corporate cost-cutting. How many jobs are being lost to this global arbitrage, as economists call it, is a matter of dispute. There are no official data, but estimates range from 500,000 to 995,000 jobs since March 2001, or somewhere between 15% and 35% of the total decline in employment. Gregory Mankiw, the politically tone-deaf chair of Bush's Council of Economic Advisors, recently assured Americans that outsourcing is "a plus for the economy in the long run"—cold comfort for those who have seen their jobs move offshore.

Stephen Roach puts IT-enabled "offshoring" at the top of his list of possible explanations for the inability of this recovery to create jobs. "In my discussions with a broad cross-section of business executives," reports Roach, "I was hard-pressed to find any who weren't contemplating white-collar offshoring."

Typically, economic stimulus policies activate "multiplier effects" that sustain economic growth over time. Higher government spending calls forth more output. Employers in turn hire more workers. New jobs put money in workers' pockets and empower workers who already have jobs to press for higher wages. And that fuels consumption. But without new jobs, that internally generated fuel is all but absent in the current upturn. Outsourcing and other trends are eroding the bargaining position of U.S. workers; predictably, wage and salary disbursements are currently running some $350 billion below the path of previous upturns. With cost-saving productivity gains and the offshoring of jobs showing no sign of abating, there is little reason to believe that this recovery will soon be able to run on its own steam. More likely, the economy will continue to grow slowly but create few new jobs.

Facing Up to our Economic Problems

This is no time to balance the budget. Dimitri Papadimitriou, president of the Levy Institute, a progressive economics think tank, estimates that the government sector as a whole (federal, state, and local) will have to run a deficit of 7% to 8% of GDP to keep the economy growing.

The public sector must both provide immediate economic stimulus and move to correct the economy's underlying problems through policies that will counteract economic stagnation and spread the benefits of economic growth more widely. Economic stimulus need not be toxic. Alternative policies are fully capable of jogging the economy back to life and at the same time creating jobs and making the economy stronger rather than weaker over the long haul.

Here is some of what has to happen. First, the Bush administration's pro-rich tax cuts, which provide less bang for the buck than more broad-based tax cuts, have to go. With 80% of taxpayers now paying more in payroll taxes than in income taxes, lowering payroll taxes would do more to boost consumer spending than cutting income taxes. But even payroll tax cuts, dollar for dollar, do less to stimulate economic growth than government spending. A one-dollar payroll tax cut adds just 90 cents to output in the following year, while a hike in unemployment benefits would generate $1 in output for each dollar the government spends, and one dollar in federal government spending to build up infrastructure would add an additional $1.80 in output over the next year, estimates David Wyss, chief economist at Standard & Poors.

There is still room for additional government outlays, especially if the Bush tax cuts for the super-rich are repealed. Relative to the size of the economy, the federal government is still no larger than its postwar average. And there is much to be done. To begin with, temporary federal unemployment benefits that were allowed to expire in December 2003 must be reinstated. Otherwise, by the middle of this year, an estimated two million unemployed people will see their benefits expire. The Bush budget proposal for FY2005 will cut another $6 billion in support for the states, but as much as an additional $100 billion in federal aid is needed to support cash-strapped states in the coming years.

Public investment, which has fallen to about one-half its levels during the 1960s and 1970s relative to the size of the economy, must be restored to maintain the nation's economic competitiveness. That means increased public investments in education, job training, and child care as well as in basic infrastructure, the environment, energy, and research and development. Many of these programs, especially spending on the environment and natural resources and on job training and employment services, have suffered deep cuts since 2000.

"In the end," as economist Anwar Shaikh points out, "government expenditures need to provide not only demand stimulus but also social stimulus." Otherwise, while GDP growth may be momentarily high(er), the well of sustained expansion and broad-based economic gains will stay dry.

John Miller is a member of the Dollars & Sense collective and teaches economics at Wheaton College.

"Jobless Recovery? Not in 2004, Economists Say," WSJ, 1/2/03; Jacob M. Schlesinger and Peter Landers, "Parallel Woes: Is the US Economy At Risk of Emulating Japan's Long Swoon?" WSJ, 11/07/01; Pam Woodall, "House of Cards," The Economist, 5/29/03; Nicholas Johnson and Bob Zahradnik, "State Budget Deficits Projected For FY2005," Center on Budget and Policy Priorities, 1/30/04; Louis Uchitelle, "Red Ink in States Beginning to Hurt Economic Recovery," NYT, 7/28/03; "The Hurting Heartland," Business Week, 12/15/03; "JobWatch," Economic Policy Institute, 1/04; Louis Uchitelle, "A Statistic That's Missing: Jobs That Moved Overseas," NYT, 10/5//03; James C. Cooper and Michael J. Mandel, "So Where Are The Jobs?" Business Week, 1/26/04; Jacob Schlesinger, "Bush's Early Electoral Edge: It's Not His Father's Economy," WSJ, 1/12/04; Stephen Roach, "False Recovery," Morgan Stanley Global Economic Forum, 1/12/04; Anwar Shaikh et al., "Deficits, Debts, and Growth: A Reprieve But Not a Pardon," Levy Economics Institute, 10/03; Randall Wray and Dimitri Papadimitriou, "Understanding Deflation: Treating The Disease, Not the Sympthoms," Levy Economics Institute, Winter 2004; Robert J. Shapiro, "Economic Recovery Remains Vulnerable to Setbacks," Center for American Progress, 12/22/03.