Historically, all recoveries from recessions precipitated by a financial crisis have been long and slow. Our current recovery from the financial crisis of 2008 is starting to look longer and more uncertain than the historical norm. The main reason is the enormous uncertainty over future taxes, spending priorities and regulations coming from the government. Our debt crisis requires significant adjustments in government policies one way or another, and private investors and consumers naturally retreat in the face of such uncertainty until the course of government policies is settled.
Our high unemployment rate means that aggregate spending (demand) on U.S. output falls short of full employment output. At the highest level of aggregation, economists divide total aggregate demand into the spending by households on current goods and services (consumption), spending by businesses on capital and capacity improvement (investment), spending by foreigners (exports) and spending by the government at all levels (government).
The Federal Reserve quickly and correctly injected liquidity into the financial system in 2008 and 2009, thus containing the scope of the financial crisis. There is nothing left for it to do other than withdraw the extra liquidity in time to avoid inflation when the right time comes.
The government increased its demand for output through several stimulus programs in an effort to fill the demand void created by the retrenchment of private-sector consumption and investment. Government stimulus required spending without tax financing because tax increases would have further reduced private consumption and investment, just as tax reductions were meant to increase them. The resulting deficit is unsustainable and has itself become a source of concern. Moreover, some of the government’s increased spending reflected long-term increases in the size of government rather than temporary countercyclical stimulus, adding to long-term debt sustainability concerns as well as concerns about government encroachment into undesirable areas. Government stimulus is now being withdrawn.
Recovery requires an increase in consumption, investment and exports sufficient to match full employment output without the artificial boost of government stimulus. So what is holding it back?
Until recently, the recovery, slow as it has been, was being led by an increase in exports. More than half of our exports go to Europe, and recent debt problems in Europe (Greece, Ireland and Portugal) have slowed Europe’s economic recovery and its demand for American exports.
The main factor holding back the recovery of investment and consumption is the large uncertainty about the environment in which firms would invest and households would spend. Businesses invest when they think it will be profitable to do so. Significant changes and prospective changes to business and especially financial regulations will take several years to clarify. Until they do, it will not be possible to estimate their cost on businesses (and thus consumers) with any accuracy.
Everyone has now accepted the fact that government spending levels and projected levels, combined with existing tax revenue and projected revenues, are not sustainable. Significant adjustments are unavoidable. The problem is that there is no consensus about what spending to cut and how much to cut it, and what taxes to change and by how much. This is particularly challenging for the three big categories that make up most of the budget (defense, Medicare/Medicaid and Social Security).
Businesses find it particularly difficult to estimate the tax treatment new investments might face and follow the sensible
path of just waiting to see.
The impasse continues between Republicans and Democrats in the Congress over the conditions they each require to reach a budget agreement. Few firms are willing to undertake new investments in such an environment.
Our faltering economy is the result of the government’s inability to get its act together and agree on the rules, and on the tax and regulatory environment, in which households and businesses will operate, consume and invest.
Until these decisions are made and the business environment clarifies and stabilizes, investment and economic recovery will suffer.