The US is still suffering from its most severe recession in seven decades. During the recession, the economy contracted by 5% and the stock market lost around half its value. President Obama cannot be blamed for the recession itself, but Republicans do blame him for the weak economic recovery (see Figure 1). Job creation has lagged behind the growth of the workforce so that unemployment remains high (see Figure 2). Joblessness rose from 4.4% in 2006 to a peak of 10% in October 2009 and is currently 7.8%. This actually understates the weakness of the labour market as participation has declined. Compared with previous postwar recessions, the employment rate has hardly recovered in this recession (see Figure 3).
House prices are still falling, two-thirds fewer new homes are being built than before the crisis and mortgage delinquencies are above 10%. The only good news is that US GDP performance is better than many other industrialised countries (the Eurozone, Japan, and the UK) and better than the 1929 collapse. But this is a low benchmark for the world’s largest economy to aim for.
Figure 1. US real GDP: Growing, but below pre-crisis rate
Source: US Bureau of Economic Analysis.
Figure 2. US unemployment remains elevated
Source: US Bureau of Labor Statistics.
Figure 3. The US labour market has recovered much more slowly this time than from previous recessions
Source: US Bureau of Labor Statistics.
Why it wasn’t worse
The Fed’s response to the crisis was unprecedented in its magnitude and speed. Interest rates have been cut to under 0.25%. Starting in 2009, the Fed embarked on large-scale quantitative easing (QE1), purchasing more than a trillion dollars in private-sector assets. In addition to QE1, in late 2012, the Fed purchased long-term Treasury bonds in an attempt to bring down longer-term interest rates (QE2), swapped short-term Treasury bills for longer-term bonds starting in September 2011 (‘operation twist’) and recently announced its intention to purchase $40 billion per month in mortgage-backed securities.
Republicans, including Mitt Romney, have criticised the Fed’s expansionary policies for risking inflation1. The Fed’s chairman, Ben Bernanke, has justified the moves by pointing to consistently low inflation, low US sovereign debt yields, and the need to restore growth. QE boosted the money supply, but most of the new money remained as reserves in private banks. The potential impact has been on longer-term and market-based rates beyond those directly controlled by the Fed.
Days after his inauguration, President Obama passed a $787 billion stimulus bill that tax cuts, increased aid to states and raised federal spending. The majority view is that the stimulus kept unemployment lower than it would otherwise have been2. For example, the non-partisan Congressional Budget Office estimated that the stimulus added an extra 0.9 to 4.7 million full-time jobs in 20103. The effect may have been higher than in normal times because interest rates were at the ‘zero lower bound’ (Christiano et al 2011); and because the relatively closed US economy was severely depressed (fiscal policy is more potent in recessions)4.
There remain sceptics (for example, Barro and Redlick 2011), including those who advance the notion of expansionary fiscal contractions (for example, Alesina and Ardagna 2012). But evidence from the IMF (2010) and others suggests that fiscal austerity is unlikely to lead to export-led growth if the other countries are also experiencing a severe contraction. Whatever the views on the merits of the stimulus, it was rather small in scale. President Obama chose not to push for a larger stimulus and was unable to enact his desired ‘second stimulus’ through a hostile Congress in 2011.
Although federal government purchases increased significantly in 2008-10 (growing by 14% in real terms – see Figure 4), their increase was not unusually large. For example, the increase in public expenditure in the mid-2000s, arising from the wars in Afghanistan and Iraq, was larger. And while federal purchases increased significantly in the first two years of the crisis, they have since decelerated and are currently declining at a faster rate than at any time in the past decade.
Figure 4. Growth of real government purchases
Source: US Bureau of Economic Analysis.
Overall across all levels of government, public purchases increased to a smaller extent in the early part of the recession (growing by only 5% in 2008-2010). Federal expenditures partly filled the gap opened up by states and municipalities, where public spending has declined, bound by rules on having balanced budgets.
Is high unemployment structural?
Monetary or fiscal stimulus can help only if unemployment is cyclical; if unemployment is structural because of skills or geographical mismatches between jobs and vacancies, expansionary policies will lead only to inflation. Even before the crisis, jobs growth lagged behind population growth over the period 2000-7 (see Figure 5), possibly for reasons related to demographic shifts, healthcare costs and inadequate skills5. Nevertheless, the depth of job falls in the recession is too large to be explained by this secular decline. Careful recent analyses indicate that unemployment is mainly cyclical: US unemployment is normal for the particularly severe recession it is experiencing6.
Figure 5. Labour market growth rates over time
Source: US Bureau of Labor Statistics.
The debt problem: Simpson-Bowles and the fiscal cliff
There is a cross-party consensus that US public debt levels are a serious problem, at least in the medium term. Debt levels rose significantly in the Great Recession (see Figure 6), but much of the increase can be explained by the automatic responses of public spending and taxes to the state of the business cycle.
The more worrying fact is that the long-run debt trend is clearly upwards. Public consumption as a share of income has not increased since the 1950s and public investment has actually declined (see Figure 7). The rise in spending is due to increases in public healthcare (Medicare and Medicaid) and social security (pensions), up from 3% of GDP in the 1950s to almost 12% today and projected to rise to 16% by 20377. Since tax revenues have not kept up with these spending trends, public debt has been marching upwards.
In December 2010, the bipartisan Simpson-Bowles commission released a majority report proposing a mixture of cuts in entitlement spending and tax reform, back-loaded to avoid exacerbating the recession (see Table 1 for the details). Broadly, the commission recommended eliminating most tax deductions, increasing revenue by about $1.1 trillion.
Part of this higher revenue would be used to reduce tax rates and overall tax revenues would be targeted as less than 20% of GDP in the long run. The remainder would be allocated to debt reduction. Social security would be brought into balance through broadening payroll tax bases and increasing the retirement age. Simpson-Bowles recommended setting targets to contain Medicare’s growth beyond 2020 (unfortunately without much detail) and containing discretionary spending growth to half the rate of inflation.
Although the commission’s proposals are broadly seen as the starting point for any serious reform, President Obama did not fully embrace it and Paul Ryan, a commission member and now Mitt Romney’s running mate, explicitly voted against it. The Simpson-Bowles commission did not obtain the supermajority required to bring forward legislation.
Political conflict peaked in the summer of 2011 over the ‘debt ceiling’. Congress not only approves tax and expenditure laws but also sets a limit to total government debt. As US federal debt approached this limit in July 2011, Congress was unable to reach an agreement on a change to the debt ceiling.
Republicans demanded that increases in the debt ceiling be linked to legislation on spending restraint. Democrats insisted that the debt ceiling be increased unconditionally or for the agreement to include tax increases (Woodward 2012). With no ‘grand bargain’ on resolving longer-term debt problems, agreement was reached to raise the debt ceiling temporarily and to find a compromise on longer-term challenges over the coming year.
Figure 6. Debt of US federal government
Source: US Bureau of Economic Analysis.
Figure 7. Expenditure breakdown of general government
Source: US Bureau of Economic Analysis.
To give incentives to both sides to arrive at a long-term compromise, the legislation required automatic public spending cuts – the Budget Control Act – to be triggered in 2013 if no agreement is reached by then. The spending cuts were designed to target the essential priorities of both parties to force the two sides to an agreement.
With the presidential election approaching, no attempt has been made to find an alternative to the ‘sequester’ scheduled in the Budget Control Act. With no change in legislation following the November elections, the sequester will be triggered in January 2013.
In addition to the spending cuts in the Budget Control Act, the ‘Bush tax cuts’ of 2001 expire at the end of 20128. The combination of these two factors is known as the ‘fiscal cliff’ (see Table 2), which will mean that taxes rise by about 2.7% of GDP and spending falls by almost 1%. This fiscal contraction of close to 3.7% in 2013 relative to current plans would almost certainly plunge the US into recession, even on the most optimistic estimates9. (Citibank forecasts a 1% decline in GDP and unemployment returning to 9% in this scenario.)10
To make things worse, the law does not address the root causes of the US debt problem – healthcare and pensions. If the economy falls over the fiscal cliff, it will cut only discretionary spending, which is not the main cause of the long-run debt problem.
The candidates’ fiscal policy proposals
No presidents can implement their budgets unmodified. The Republicans will almost certainly control the House of Representatives and the Democrats are expected to retain the Senate11. Whoever wins the presidential election is likely to face divided government.
Fiscal policy in the short run
As discussed above, the aggressive monetary and fiscal action during the nadir of the Great Recession helped avoid a repeat of the 1930s. Furthermore, immediate action on the debt level is unwarranted as real interest rates on US Treasury Bills are at historic lows. There is no correlation between US debt levels and market interest rates, and there are currently no serious market fears of US sovereign default (see Figure 8).
Governor Romney’s platform calls for an immediate 5% cut in non-defence discretionary spending and he was strongly against President Obama’s proposed second stimulus programme. The Republicans’ plan favours tax cuts that go beyond extending the Bush tax rates.
President Obama’s recent rhetoric has indicated that he too is currently more dedicated to contracting rather than expanding public expenditures, but Democrats are keener to have military expenditures share the burden of spending cuts. The president and congressional Democrats have generally expressed support for extending the Bush tax cuts, except for higher-income households.
Both candidates have expressed a desire to avoid the fiscal cliff. Congressional leaders are already negotiating details of an agreement and it is probable that some agreement will be reached to postpone the sequester and prolong the 2001 tax cuts for most households before the January 2013 deadline. This would allow whoever is president some time to reach a broader bargain. But the enormous political uncertainty this engenders does the economy no favours12.
Fiscal policy in the long run: Taxes
The Republicans’ plan would extend all of the Bush tax cuts indefinitely (at an annual cost of $450 billion), reduce marginal income taxes by an additional 20%13 (at an additional cost of $250-480 billion) and reduce corporate tax rates from 35% to 25%14. To finance these cuts, there would be an elimination of unspecified tax deductions. These estimates may overstate the budgetary cost of these tax cuts if lower tax rates stimulate economic growth15. Current evidence on the incentive effects of lower taxes on the rich do not give cause for such optimism, particularly as income inequality is already so high in the US16. Indeed, US growth was not spectacular in the period after the 2001 tax cuts were implemented.
Figure 8. The level of debt has not been correlated with real interest rates
* 10-year treasury rate deflated by lagged annualised ten-year inflation.
**market implied real interest rate.
Source: US Bureau of Economic Analysis; Federal Reserve Board.
But even allowing for generous growth effects of tax cuts and assuming elimination of deductions is feasible – a best case scenario – Governor Romney’s tax reform will contribute nothing to reducing the deficit but everything to financing tax cuts.
The most detailed information available on President Obama’s plans is in the 2013 budget proposal. His tax reform would eliminate tax breaks for ‘millionaires’ and reduce the tax rate applied to deductions to a maximum of 28% for households with incomes exceeding $250,000. President Obama also proposes making the Bush tax cuts permanent for households earning less than $250,000, but allowing them to expire for others.
Combined, these reforms are estimated to increase revenues by $150 billion a year, 1% of GDP17. These alone would be insufficient to close the budget gap in the long run and come on top of extending the Bush tax cuts for lower-earning households, costing $350 billion a year.
Fiscal policy in the long run: Spending
Governor Romney and his running mate have proposed capping public spending at 20% of GDP and to do so through cuts in discretionary non-defence spending and through restraint in entitlement spending. The main driver of long-run debt increases is healthcare18. The ‘Ryan plan’ proposes that from 2023, seniors will be provided with vouchers to buy health insurance from private insurers or from Medicare itself. The value of the vouchers will be linked to a price determined through competitive bidding19 with the aim of reducing Medicare costs through sharper competition among insurers.
But if healthcare cost inflation is due to increasing demand (Hall and Jones 2007) or a rise in the underlying costs of healthcare provision, such competition may have little effect. As a backstop, Paul Ryan proposes capping Medicare spending at a growth rate 0.5% above the rate of GDP growth after 2023.
President Obama is committed to implementing his Affordable Care Act which combines expansion of coverage with controls over the growth of Medicare expenditure, through for example, lower reimbursement rates for hospital services. The Congressional Budget Office (CBO 2011) estimates that the law will result in a net reduction in federal deficits of $118 billion from 2010 to 2019. Governor Romney is committed to repealing the Affordable Care Act. .
There is little information on what either candidate would do on social security reform. Media reports suggest that the candidates allow the possibility of increasing the retirement age – an almost inevitable reform.
Given the enormity of the short- and long-run fiscal challenges facing the US, the lack of policy detail from both presidential candidates is disappointing. The initially aggressive action by policymakers in the Great Recession was impressive, but political gridlock since then has hampered attempts to deal with the fiscal challenge. The Simpson-Bowles proposals should be the starting point in this debate with a clear need to specify more clearly how to raise tax revenues and contain healthcare and social security costs.
The Simpson-Bowles proposals should be the starting point in this debate with a clear need to specify more clearly how to raise tax revenues and contain healthcare and social security costs.
Table 1. The Simpson-Bowles commission’s proposals
Table 2. The ‘fiscal cliff’: Changes in tax and expenditures policy scheduled in current law
Daniel Aaronson, Jonathan Davis and Luojia Hu (2012) "Explaining the Decline in the U.S. Labor Force Participation Rate", Chicago Fed Letter.
Alberto Alesina and Silvia Ardagna (2012) "The Design of Fiscal Adjustments", NBER Working Papers No. 18423.
Alan Auerbach and Yuriy Gorodnichenko (2012a) "Fiscal Multipliers in Recession and Expansion", in Fiscal Policy after the Financial Crisis, NBER.
Auerbach, Alan and Yuriy Gorodnichenko (2012b) "Measuring the Output Responses to Fiscal Policy", American Economic Journal: Economic Policy 4(2).
Bagaria, Nikita, Dawn Holland and John Van Reenen (2012) "Fiscal Consolidation During a Depression", National Institute Economic Review.
Barro, Robert and Charles Redlick (2011) "Macroeconomic Effects from Government Purchases and Taxes", Quarterly Journal of Economics 126(1): 51-102.
CBO (2011) "CBO’s Analysis of the Major Healthcare Legislation Enacted in March 2010".
Christiano, Lawrence, Martin Eichenbaum and Sergio Rebelo (2011) "When is the Government Spending Multiplier Large?", Journal of Political Economy 119(1): 78-121.
Daly, Mary, Bart Hobijn, Aysegul Sahin and Robert Valletta (2012) "A Search and Matching Approach to Labor Markets: Did the Natural Rate of Unemployment Rise?", Journal of Economic Perspectives 26(3): 3-26.
Hall, Robert and Charles Jones (2007) "The Value of Life and the Rise in Health Spending", Quarterly Journal of Economics 122(1): 39-72.
Ilzetzki, Ethan, Enrique Mendoza and Carlos Vegh (2012) "How Big (Small?) are Fiscal Multipliers?", forthcoming in the Journal of Monetary Economics.
IMF (2010) World Economic Outlook, chapter 3: "Will it Hurt? Macroeconomic Effects of Fiscal Consolidation" by Daniel Leigh, Pete Devries, Charles Freedman, Jaime Guajardo, Douglas Laxton and Andrea Pescatori.
Krueger, Alan (2011) "Understanding Differences in Job Growth in Europe, Canada and the U.S.A: What Went Wrong in the U.S.A.?", mimeo, Princeton.
Lazear, Edward and James Spletzer (2012) "The United States Labor Market: Status Quo or A New Normal?", NBER Working Papers No. 18386.
Piketty, Thomas, Emmanuel Saez and Stefanie Stantcheva (2011) "Optimal Taxation of Top Labor Incomes: A Tale of Three Elasticities", NBER Working Papers No. 17616.
Ramey, Valerie (2011) ‘Identifying Government Spending Shocks: It’s All in the Timing’, Quarterly Journal of Economics 126(1): 1-50.
Romer, Christina and David Romer (2010) "The Macroeconomic Effects of Tax Changes: Estimates based on a New Measure of Fiscal Shocks", American Economic Review 100(3): 763-801.
Daniel Wilson (2011) "Fiscal Spending Multipliers: Evidence from the 2009 American Recovery and Reinvestment Act", San Francisco Federal Working Paper No. 10-17.
Bob Woodward (2012) The Price of Politics, Simon and Schuster.
1 See here.
2 See here.
3 "Estimated Impact of ARRA on Employment and Economic Output"; for further evidence, see Wilson (2011) and the references therein.
4 See Auerbach and Gorodnichenko (2012a, b) and Ilzetzki et al (2012). For an application to the effects of UK’s fiscal contraction see Bagaria et al (2012).
5 Aaronson et al. (2012) suggest that demographic patterns explain this pattern. Krueger (2011) compares the US with Canada to show that high employer health care costs are a large part of the explanation.
6 See Lazear and Spletzer (2012); Daly et al. (2012) find that the natural rate of unemployment has risen slightly to 5%, well below the current level of 7.8%.
8 The tax cuts were initially legislated to expire after ten years and have been subsequently extended.
9 Current US GDP growth is approximately 1.5%. In a review of the literature on expenditure multipliers, Ramey (2011) gives a consensus view centred around unity. A $110bn cut in public spending would cut GDP growth by approximately 0.7%. Even under a more conservative estimate of 0.4 (Barro and Redlick 2011), this figure would be approximately 0.3%. Romer and Romer (2010) estimate a tax multiplier exceeding 2. Using a far more conservative estimate of 0.5 would be enough to eliminate entirely the 1.5% GDP growth rate, given a tax increase of 2.7% of GDP.
10 Citi Research, U.S. Macro Focus of 21/9/12.
11 The Intrade betting market puts the probability of Democratic control over the Senate at 62% (10 October 2012).
12 See CEP’s US Election Analysis on economic recovery and policy uncertainty.
13 See here.
14 These are conservative estimates. Extending the Bush tax cuts would cost $4.5 trillion over ten years according to the CBO. The additional reduction in marginal rates would cost $250 billion per year, even if it only applied to those earning above $200,000. Cutting the corporate tax rate would cost $96 billion a year (see brookings.edu). We assume, as do most estimates that these latter costs will be fully covered by broadening the corporate tax base and eliminating tax loopholes, although no specifics have been provided about these plans. If Romney cuts taxes at this rate for all households, the cost would be higher, at $480 billion.
15 The Tax Foundation estimates that the 60% of the revenues lost due to the Romney tax cuts would be recovered through higher growth.
16 For example, see Piketty et al (2011) and CEP’s US Election Analysis on inequality.
17 According to the CBO, capping deductions will save $50 billion a year and allowing the Bush tax cut to expire will save $100 billion a year.
18 See also CEP’s US Election Analysis on healthcare reform for more detailed analysis.
19 Formally, insurance companies and Medicare will post their insurance premia and the second-to-least expensive will determine the value of the vouchers. This is unless Medicare posts the lowest bid, in which case vouchers will be set to cover the costs of Medicare itself. Recipients will then be entitled to use their voucher to choose among the alternative plans, while paying or pocketing the difference in price.