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August 25, 2011

Bolstering An Economy That Has Fallen $1 Trillion Below Potential

Andrew Fieldhouse

When Congress returns to session, policies for job creation are expected to be at the forefront of the legislative calendar. The federal government can and should put Americans back to work, as was done in the Great Depression and earlier in this recession. Numerous policies to boost economic activity and employment—including infrastructure spending, unemployment benefits, and tax cuts—were beneficially employed in the 2009 American Reinvestment and Recovery Act, but on an inadequate scale, as measured by the gap between actual and potential economic activity. Millions of Americans could be put back to work by expanding fiscal policy on an appropriate scale, meaning hundreds of billions of dollars in additional government spending.

The Recovery Act did what it was designed to do: it turned the economy around and increased employment by millions of jobs. The economy was plunging at an annualized rate of 8.9% in the fourth quarter of 2008, the last quarter before the Recovery Act began to support the economy. The Recovery Act was signed into law in February 2009 and the additional government expenditures and tax cuts quickly surged to an annualized rate of $319 billion (2.3% of gross domestic product) in the third quarter of that year. As the Recovery Act ramped up, the economic contraction slowed sharply to 0.7% in the second quarter of 2009 and growth resumed in the third quarter; this was no coincidence. Increased economic activity boosted employment, everything else being equal, and the economy was creating jobs by the first quarter of 2010, albeit from a deeply depressed level of employment. Estimates by private sector forecasters and the Congressional Budget Office suggest that the Recovery Act increased employment by roughly 3-4 million jobs—in line with administration projections—but this fell far short of recouping the number of jobs lost. Monthly job losses began slowing in February 2009 when the Recovery Act first kicked in, but the economy still lost a staggering 8.8 million jobs between February 2008 and February 2010.

The Recovery Act was simply not designed to provide the degree of support needed to cushion the implosion of the housing bubble and fall in demand, as is demonstrated by the output gap—a key metric of economic health. The output gap measures the difference between actual output (GDP) and potential output, the sustainable level of economic activity achievable with high resource utilization, namely full employment. (Potential output is not a ceiling for economic activity, but resource scarcity builds inflationary pressures above this level.) CBO’s projections of potential GDP show that the output gap peaked at $1.2 trillion (-8.2%) in the third quarter of 2009 and then shrank as a result of the Recovery Act (see chart).  When expenditures and tax cuts peaked in the second quarter of 2010, the Recovery Act closed roughly $445 billion, or 31%, of what the output gap would have been without the Recovery Act. In other words, returning the economy to potential output and lowering unemployment to its pre-recession level of 5.0% would have required a stimulus package roughly three times the magnitude of the Recovery Act. The $821 billion cost of the Recovery Act, spread out over more than three years, was a drop in the bucket for a $15 trillion economy, as Paul Krugman presciently argued two and a half years ago.

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The economy still faced a staggering output gap of $1.0 trillion (-6.3%) in the second quarter of 2011. In other words, the depressed economy is resulting in roughly $1 trillion in forgone production and national income annually. (Without the Recovery Act, the output gap would be closer to $1.3 trillion, or -7.9%.) There is still much need and scope for expansionary fiscal policy. Boosting economic activity by $500 billion (+3.3%) to halve the output gap would require roughly $357 billion of well spent fiscal support, such as infrastructure spending, unemployment insurance, and aid to state budgets. If a package included tax cuts, which generate less economic activity per dollar (because tax cuts are partially saved), a bigger package would be required to generate this level of economic activity. Until the economy approaches potential output, there is too much underemployed labor and unused industrial capacity to generate worrisome inflationary pressures.

Meaningfully addressing the crisis in the labor market and trying to restore the economy to potential requires hundreds and hundreds of billions of dollars of deficit financed fiscal stimulus. The Federal Reserve cannot spur a robust economy on its own—the economy would be booming if low interest rates were a panacea for growth—so more fiscal support is needed. The federal government can borrow at historically low interest rates and public borrowing is not crowding out private sector investment; the near-term deficit does not matter while the economy remains depressed and interest rates remain at rock bottom lows. Big deficits are a reality of a catastrophic recession and there are worse things than rising public debt, namely a stagnant economy, staggering underemployment, lost productive capacity, and trillions of dollars of forgone production and wealth. According to CBO, the financial crisis and depressed economic output have already lowered potential output by roughly 2% in the second half of next decade; more costly economic scarring will be incurred if the faltering recovery is not bolstered.

Congress has policy levers to accelerate economic growth and expand employment, many of which were beneficially employed in the Recovery Act. Expansionary fiscal policy needs to be reapplied on the order of $300 billion to $400 billion a year for at least two years to push the economy from neutral to high gear and put America back to work.

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