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August 01, 2011

Graph of the Day: The Dismal Economy That Washington Keeps Ignoring

Andrew Fieldhouse

On Friday we learned that the U.S. economic downturn has been much more severe than previously understood and the economy is growing much too slowly to keep unemployment from rising. The anemic recovery has been losing steam for months, explaining the sharp deceleration in employment growth in May and June. As the U.S. Congress frantically debates an eleventh hour resolution to an artificial crisis of epic proportions, the real crisis in the labor market goes tragically ignored—and it is about to be amplified by bad policy choices. Unfortunately, the only conceivable debt ceiling compromises will further slow economic growth and exacerbate the unyielding crisis in the labor market.

We thought the economy had slowed, but the deceleration was more acute than realized. The economy has yet to recover to pre-recession output; we thought it had. It turns out that the economic downturn was 24% deeper than previously assumed, and actual economic output currently stands a staggering $882 billion (5.6%) below potential (the level attainable with full employment and industrial capacity utilization). As a rule of thumb, real (inflation-adjusted) economic growth music exceed an annual rate of 2.5% just to keep the unemployment rate from rising (see Paul Krugman on Okun’s law, the relationship between growth and unemployment). Unfortunately, the economy has been growing at considerably slower rates for the past three quarters (see chart). Annualized growth in the first quarter of this year was revised downward by 1.5 percentage points to a meager 0.4%. In the first half of this year, the economy has grown at an annualized rate of only 0.8% - a third of the growth needed to keep the unemployment rate from rising. Without significantly faster growth, the unemployment rate will continue to trend higher.

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This report leads to two conclusions: the downturn was much worse than we realized, and the slowing recovery is much weaker than we assumed. Past economic policy was informed by even older, less accurate data, and consequently severely underestimated the severity of the downturn and needed policy response. At its peak in 2010, the American Recovery and Reinvestment Act injected $395 billion in investment, transfer payments, and tax cuts into the economy, but that still left an economy $985 billion (6.3%) below potential. The $821 billion Recovery Act was way too small to cushion the fallout from $7 trillion in housing wealth evaporating and the ensuing financial crisis; the subsequent piece meal extensions of unemployment benefits, tax cuts, and aid to states has also been lacking. The Recovery Act unquestionably helped, boosting employment by 3-4 million more jobs, but it will take another 11 million jobs to return unemployment to pre-recession rates.

We have the policy levers to boost the economy and lower employment: direct infrastructure investment, increased safety net spending, targeted tax rebates, state fiscal relief, and public works projects. These policies require bigger deficits, but with monetary policy effectively maxed out and a depressed, shaky economy, a big deficit is a good thing, for the time being. The United States has the ability to service our debt and meet obligations to citizens, but Washington is wrongly focusing on this year’s deficit rather than the interrelated problems of a weak economy coupled with long-term structural deficits. These GDP numbers should serve as a clarion call to refocus Washington’s attention back to the real economic crisis: jobs and the economy.

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