Recovery By The Numbers
A single number tells us most of what we need to know about the recession and prospects for recovery. That number is gross private domestic investment. It averaged 16% of the GDP in 2006-7, 11% in 2009, 12.4% in 2010. For the first half of 2011, it was 12.6%. This decline is large enough to account for most of the increase in unemployment. It must be reversed; there is no other way of returning to high employment.
Households are doing their duty, spending 95% of their income. Consumption is a dependent variable; it will never pull us out of recession. Consumption stimulus policies have failed and wasted tax revenue. Only more jobs and paychecks can do the job.
The Federal Reserve has maintained a discount rate of one quarter of one percent for 3 years to encourage lending and investment. It has done as much as it dared to raise exports and reduce imports by increasing the money supply and devaluing the dollar.
Government has increased its share of GDP from 19.2% in 2006-7 to 20.9% in 2009 and 20.6% in 2010. The increase in the deficit did not reduce unemployment. Can government increase its expenditures enough to counteract the decline in private investment? Can such an increase stimulate private investment? Is it possible to finance compensatory government spending by taxation?
Arguments about the size of government are not just ideological; they are economic. At what point does increased taxation reduce growth? At what higher point does it reduce revenues? If the government spends 20% of the GDP, financed by taxes, tax rates on the rest of the economy (business, nonprofits, households) must average 25%. If government were to spend 25% of the GDP, tax rates would have to average 33%. Much depends on how government structures taxes and spends revenues. There is no sure knowledge, but I suspect that the tax rate that begins to reduce economic growth is much closer to 25% than to 33%.
Government has been spending well in excess of its ability to collect revenue with the current tax structure. To compensate for the shortfall in private investment, it would have to spend at least 24% of GDP. Expenditures for social security and various health programs, especially Medicare and Medicaid, are scheduled to escalate. The share spent on interest on the national debt will depend on decisions in the near future, but it will rise. Taxation cannot pay all these bills coming due.
Why is gross domestic private investment so low and what can be done about it? It has three components. One is inventory, always moving up and down. Its effects on employment are small, short-run. Another is residential construction. We know that it is not going to pull us out of recession and may continue dragging us down. Its rebound is dependent on increases in employment and household incomes. Once a cause of recession, it is now an effect. Nonresidential construction is down. It includes infrastructure -- new and expanded production facilities -- which are the great job-creators. The last component, equipment and software, has not declined, and that is a problem.
Some equipment and software is needed for new plants, to produce more products, new products, or better products. But some is "luddist" -- that is, it increases productivity, reducing the need for labor per unit of output. Depending on how it is used, it could contribute either to creating or to destroying jobs.
Total factor productivity has risen 3.2% in each of the last 2 years, the highest rate since the BLS started keeping tabs in 1987. The average long-term rate has been around 1%. We know that it is investment, not labor, that is mainly responsible, because labor productivity increased by only half, to 3.6%, while total factor productivity tripled. We can produce the same output today with 7% less labor than two years ago. Investment in equipment and software is reducing employment.
It is the long-run investment in new plant, new and better products, and new methods of production that keeps the economy growing. Expectations are all-important for investments that take years if not decades to pay off. What are expectations about? Demand, of course, taxation, inflation, energy costs, employer labor, and health care costs. Right now, business anticipates rising health care costs; many businesses expect higher energy costs, and all anticipate higher taxes. It is not just the sign of the anticipated change that matters; it is the size and the uncertainty. Without significant change in expectations, there will be at best slow and limited recovery of job-creating investment. Business will invest most of its profits, just not here.
Almost anything we do now to reduce future deficits and promote long-term growth will increase unemployment in the short run. Kicking the can down the calendar increases the magnitude of the problem and the cost of dealing with it. But it is possible to make hard choices that do not reduce employment today -- only down the road under more propitious circumstances, if at all. Such choices can reverse expectations. But they must be more than promises; they must be embodied in legislation.
Income tax reform is a must. If it were not so infuriatingly complex and discriminatory, there might be less opposition to tax increases. But the burden of coping with growing entitlement costs must be on the expenditure side. Raising the age for Social Security benefits and Medicare eligibility, cost-benefit limits for health insurance reimbursement, should obviously be major components. Health care costs, which have more than tripled in the past half-century as a share of GDP, must be slashed, not just shifted. Elimination of the ethanol subsidy and subsidies for other high-cost products are examples of cuts beneficial for growth.
It is up to Congress to change investor expectations of escalating energy costs, tax rates, health costs, and the prospect of a long-term zero-growth economy. Speeches are no substitute for legislation.