The current postcrisis economic recovery, though punctuated so far by two “swoons,” growth scares in early 2011 and late 2012, has passed its 48th month. These past swoons notwithstanding, virtually no one is thinking of deflation or recession, even though second-quarter 2013 growth looks to be below 1 percent, perilously close to stall speed. The past two postswoon recoveries have not gotten the economy entirely back on track, but markets and, more notably, the Federal Reserve are betting on the third time being lucky. Instead of resting on this wishful thinking, Congress and the Fed need to start exploring measures that will prolong the expansion.
Key points in this Outlook:
- Economic indicators and long-term business cycle patterns suggest that the United States may be in another recession by early 2014.
- Two post–financial crisis economic swoons have been curbed with easy money and fiscal stimulus, but flat retail sales, slowing employment growth, and a faltering housing sector may prevent these strategies from working again.
- To prolong the expansion, Congress and the Fed should enact near-term fiscal stimulus, lower tax rates and broaden the tax base, deregulate the financial sector, and focus on maintaining low and stable inflation.
“The first time I was a fool. I never knew that love could be so cruel. It happened to me again. Third time lucky.”
—“Third Time Lucky,” Foghat
Many casual observers would argue that all is well with the US economy. Consensus and the Fed are predicting robust 2.5–3 percent growth over an extended period with no deflation. Housing is “back,” and US stocks are at record highs. The “bond bubble” has burst as investors sell bonds in the face of the rising interest rates that will inevitably accompany recovery. The United States seems to be in the best economic position in the world.
Or so goes the consensus view. There is another possible scenario: Suppose the financial crisis and the Great Recession have returned the United States to a more normal sequence of business cycles. Suppose we are closer to the long-run (33 cycles between 1854 and 2009) average where expansions were shorter (about three years as opposed to the post-1961 average of six years) and contractions a bit longer (18 months) than the 12-month contractions that are the post-1961, seven-cycle norm?
By the long-run standard or even by the full post–World War II (1945–2009) standard that saw expansions averaging 58.4 months, the current expansion, at 49 months (54 months by year-end, when growth is widely forecast to be 3 percent), is getting close to its end. The standard deviation of postwar expansions is 33.4 months, so we are well within the window for onset of a recession. Based on the full long-run National Bureau of Economic Research (NBER) sample, with an average of 38.7 months, the current expansion is just two months from being a third longer than its expected length.
"The current expansion, at 49 months, is getting close to its end."Statisticians like Nate Silver, who recently left the New York Times, where he was described as a “disruptive outsider,” for ESPN and ABC News, were remarkably successful in predicting the outcome of the 2012 presidential election, right down to the state-level results. Largely, they let the numbers speak rather than listening to experts and journalists. A “disruptive outsider” watching the US economy in summer 2013 with this same strategy could reasonably predict a recession beginning as soon as the first quarter of next year.
US Business Cycles
Given that the average length of a US business cycle expansion during the 33 cycles from 1854 to 2009, as determined by the NBER, was 38.7 months (standard deviation, 27 months), while the postwar average expansion (1945–2009) lasted 58.4 months (standard deviation, 33.4 months), two things stand out. First, expansions since World War II have gotten longer, and second, the length of expansions varies greatly over different cycles. The postwar expansions have seen more variability in length over cycles than during the full long-run period.
Since 1961, when macro policy measures have arguably been applied more proactively, the average expansion has lasted even longer—71 months (standard deviation, 36 months), or nearly twice the long-run average of just over three years. The suggested trend is toward ever-longer expansions whose length varies substantially from cycle to cycle. The post-1961 expansion sample of seven cycles includes the brief July 1980 to July 1981 expansion that was truncated by ongoing efforts to bring down double-digit US inflation. Excluding that unusually short expansion, the post-1961 average was an even more impressive 81 months.
During the same post-1961 period, the average business cycle contraction lasted a mere 11.9 months, less than the long-run average of 17.5 months. The shortened contraction average includes the July 1981 through November 1982 (16-month) contraction, which was tied to the sharp monetary tightening engineered by Paul Volcker aimed at squeezing out inflation.
Since 1961, American households and businesses and the investors who trade stocks, bonds and commodities, and foreign currencies have grown accustomed to expansions of six years or more followed by brief contractions of about a year or less. The March 1991 to March 2001 decade-long expansion, the high point of the “Great Moderation” that saw higher growth, lower unemployment, and lower inflation, spawned the hope that the business cycle was dead.
Arguably, post-2001 striving to recapture the blissful decade of the 1990s, the American economy’s “golden age,” produced the financial excesses that ultimately triggered the 2008 financial crisis. The US economy peaked in December 2007, at which time financial stresses were accumulating rapidly and the Bear Stearns crisis and collapse, which triggered six months of extreme turmoil culminating in the collapse of Lehman Brothers, was just three months away. The Fed had begun to lower interest rates, and growth was slowing (figure 1). Zero interest rates were still not even being considered, and quantitative easing (QE), just 15 months away (March 2009), was not even imagined.
The Current Cycle
The last two US economic swoons, in the first quarter of 2011 (growth at 0.1 percent) and the fourth quarter of 2012 (growth at 0.4 percent), were arrested with the combination of easier money and extra fiscal stimulus. This time, unfortunately, we are not going to be so lucky.
As I have noted, fiscal policy is already contractionary. The deficit reduction brought on by that now-regretted austerity, entailing a 2013 fiscal drag equivalent to about 2 percentage points of GDP, is encouraging on the fiscal health front. But it is also slowing economic growth.
Monetary policy has also turned unsupportive of growth in 2013. Although it could be providing modest support, or at least not imparting drag, the Fed’s recent talk of “tapering” (reducing QE) has boosted both uncertainty and interest rates. Both are acting as drags on the midyear economy, in addition to the fiscal drags resulting from higher taxes and lower spending growth. Since Fed Chairman Ben Bernanke first raised the taper issue on May 22, the economy, already on track to slow thanks to these fiscal and monetary drags, has slowed sharply.
Since May, most growth forecasts for the second quarter of 2013 have dropped, from the respectable 2.5 percent pace predicted earlier by the Fed and most private forecasters, to below 1 percent. Reported retail sales, housing stocks, and investment have been especially weak in May and June. The pace of consumption growth has faded since the above-trend 2.8 percent level in the first quarter that accounted for all of the reported 1.8 percent GDP growth rate during that period.
Consumption held up well earlier this year, thanks in large part to elevated late-2012 dividend payments made in anticipation of higher 2013 tax rates. Consumption growth has also been supported by the wealth rise generated by rising housing and equity markets, in turn partly attributable to the Fed’s fourth-quarter 2012 commitment to extended ZIRP (zero interest rate policy) and QE3.
The post–May 22 taper talk has boosted uncertainty, removing the support for consumption coming from QE3 and ZIRP. Retail sales growth, a good proxy for consumption and confidence, slowed sharply in June as the taper talk uncertainty grew after Bernanke’s confusing press conference following the June 19 Federal Open Market Committee meeting.
Excluding automobile sales, which have remained robust thanks to low interest rates and aggressive promotion, retail sales were flat in June versus a modest expectation of a growth rate close to 1 percent. Retail sales growth during this expansion has been especially weak, rising at an average nominal year-over-year pace of about 4.4 percent (about 2.4 percent real). (See figure 2.) But in June, the year-over-year growth rate of retail sales dropped to 4 percent from 5 percent in May, below the average tepid growth rate during the current postcrisis expansion that began in June 2009.
The newly vibrant (since 2011) housing sector has also begun to falter at midyear. June housing starts dropped sharply by 9.9 percent to 836,000 units from a more robust 928,000-unit pace in May. June housing permits fell sharply by 7.5 percent, an indication of weaker second-half housing starts. It appears that the full percentage point increase in mortgage interest rates from about 3.5 percent to 4.5 percent, since partially reversed but still volatile, that came after taper talk has started to slow the housing sector. Monetary drag is beginning to hurt the economy, perhaps explaining why Bernanke, during his July 17–18 testimony on the economy to Congress, backed away from tapering QE while pushing an end to ZIRP further into the future.
Postcrisis Employment Growth
During the current expansion, since June 2009, employment growth has been substandard and volatile. (See figure 3 and the longer-sample figure 4.) During five post-1961 expansions through 1990, employment growth averaged between 2.5 and 3 percent, excepting the brief one-year July 1980 through July 1981 expansion, when the average was just 0.41 percent.
The 10-year March 1991–March 2001 “golden age” expansion saw employment growth averaging a some-what lower 1.91 percent. Economic growth was supported by higher productivity growth that, in turn, was no doubt enhanced by labor-saving technological changes including those embodied in the information technology (IT) revolution and its associated improvements in communication. After 1985, employment growth during expansions continued to fall. A fuller understanding of the steady deceleration of employment growth during recoveries would surely benefit us now as we struggle with a tepid labor market.
The last two expansions have seen much slower average year-over-year employment growth, just 0.66 percent during the 2001 to 2007 “jobless recovery” and today virtually zero growth during the June 2009 to June 2013 “more jobless recovery.” (See figure 3.) The very low employment growth numbers since the 2001 expansion reflect a stretch of negative monthly year-over-year employment numbers, another indicator that labor growth suffers from aggressive layoffs even during the early phases of expansions. Further, the current expansion’s employment growth, while tepid, has been unusually volatile. See the note for figure 3 for details on employment growth during all post-1961 expansions.
In view of these numbers, it is little wonder that despite recent monthly job growth averaging 190,000, there is much disappointment and dissatisfaction with labor market performance. As Bernanke said in his July 17 testimony to Congress: “Despite these gains (in employment growth), the jobs situation is far from satisfactory, as the unemployment rate remains well above its longer-run normal level, and rates of unemployment and long-term unemployment are still much too high.”
The unemployment rate, seemingly stuck at 7.6 percent, captures the unsatisfactory state of US employment growth during the current expansion. Much of the reduction in the unemployment rate is due to rising dropouts from the labor force as discouraged job hunters give up looking for work.
Figures 3 and 4 display clearly the slowing trend of US employment growth, especially since 1985. A full explanation is beyond this piece, but substitution away from labor appears to have risen since the mid-1980s, due probably to the rise of labor-saving technology related to the IT revolution. More costly labor inputs have also resulted from the rising cost of fringe benefits, especially health care. Modern electronic productivity enhancers like ever-more-versatile laptops, tablets, and smartphones do not require much maintenance, and you just throw them away when newer, better models become available.
Improving the Outlook
The path toward an early-2014 recession, while probable based on business cycle statistics, is not unalterable. The solutions are well-known. Four stand out.
First, Congress still needs to enact a comprehensive budget agreement that includes modest near-term (during FY 2014 that begins October 1, 2013) fiscal stimulus, primarily by reversing the early-2013 tax increases. That step would add about $180 billion per year to aggregate demand, provided that households and firms were confident that deficits after 2015 will be steadily reduced by a rationalization of entitlements: Social Security and government health programs.
Rationalization of Social Security requires both a gradual rise in the eligibility age for retirement benefits to 70 years to reflect longer life expectancy, and a correction of the current indexing formula that overcompensates beneficiaries for inflation. Health care costs would be substantially reduced by confining government programs to coverage of larger health costs, those exceeding an inflation-indexed $2,000 per year. Households with incomes above the poverty line would bear costs below that level, giving them an incentive to question the cost of routine health care procedures. Low-income households would receive government support to raise their health care coverage to adequate levels.
Second, faster growth through tax reform (lower tax rates and a broader tax base for households and corporations) makes deficit reduction a positive-sum game by tying higher tax receipts to higher incomes, not to higher tax rates. Higher tax rates reduce growth by reducing work incentives and distorting resource allocation. For example, continued tax breaks for housing, employer-provided health care, and US sugar producers, to mention only a few, do not enhance growth and actually reduce tax revenues. Phasing out tax expenditures (loopholes) could raise nearly $1 trillion in revenue. That is enough to finance growth-enhancing tax rate reductions, including a reduction in tax rates on capital gains and capital acquisition, in recognition of the fact that capital formation boosts growth.
Third, deregulation of the financial sector, reversing the damage done by the Dodd-Frank Act and deregulation of the health care sector, would further enhance growth. The sharp rise in uncertainty and costly compliance engendered by increased regulation of these and other industries has penalized growth.
Finally, the role of monetary policy needs to be gradually returned to maintaining low and stable inflation. Monetary policy cannot persistently enhance growth, lower unemployment, or otherwise alter real economic performance. Attempting to do so has led to disappointment. The rising disenchantment with quantitative easing reflects this reality. The transition to inflation-only targeting for monetary policy needs to be clearly articulated and undertaken gradually. The path may not be smooth as the elevated volatility and growth-reducing uncertainty accompanying the recent, too-abrupt tapering has shown.
These are all familiar proposals. Sadly, the lack of progress in enacting any of them is also very familiar. That is why there exists a high probability, tied to the shape of past expansions, of a recession beginning in early 2014. Let us hope that as the economic data continue to suggest the recession outcome, policymakers will be moved to enact measures that will prolong expansions.
1. See John H. Makin, “Is This the Golden Age?” AEI Economic Outlook (May 1995), www.aei.org/outlook/economics /fiscal-policy/is-this-the-golden-age/; and John H. Makin, “The End of the Golden Age,” AEI Economic Outlook (April 1999), www.aei.org/outlook/economics/is-the-golden-age-over/.
2. Ben S. Bernanke, Semiannual Monetary Policy Report to the Congress, US House of Representatives Committee on Financial Services, July 17, 2013, www.federalreserve.gov/newsevents/testimony/bernanke20130717a.htm.