Complaints about the sluggish recovery from the Great Recession are rampant and for good reason. It is by far the slowest of the recoveries from the nine recessions since WWII. Productivity and job growth have been anemic, while median inflation-adjusted household income is down.
Such extended malaise should indicate a longer-term structural problem within the economy. Instead, the problem is being treated as an extreme business cycle phenomenon. Thus, the major policy response has been monetary stimulus, which has been invoked at unprecedented levels with the result of near zero short-term interest rates for the past six years. To accomplish this historic feat, the Fed’s balance sheet was expanded from around $800 billion in 2008 to $4.5 trillion today.
The obsession over monetary policy is mind boggling. Congress holds periodic hearings on the Fed’s performance relative to its “dual mandate”: ensuring stable prices and full employment. The hearings are often contentious, as members demand to know why more progress is not being made. The financial media conduct daily assessments of when the Fed will begin to raise interest rates, as if increasing short-term rates from zero is somehow going to have a dramatic negative effect on the economy.
The stock market acts like the recovery is better than it actually is. This is because the Fed’s largesse has pumped liquidity into financial markets, which has lifted prices. In addition, corporations have used cheap money to buy back huge amounts of their outstanding stock, thereby artificially raising per share earnings. This, in turn, has contributed significantly to higher stock prices and hence a modest wealth effect on consumption.
The other business cycle stabilization tool, fiscal policy, has been missing in action. Republicans blame excessive government spending for low growth rates, arguing that it interferes with the private sector’s investment decisions. Under such pressure, the federal budget deficit has fallen substantially, but with no apparent effect on the rate of growth. For their part, the Democrats have focused on income redistribution, supporting initiatives such as raising the minimum wage, expanding the maximum income level eligible for overtime pay, and adjusting the tax code to deal with growing income inequality. Whether or not such changes have merit in a social welfare sense, they are not going to solve the core growth problem.
So, from a policy perspective, we have a castle-built-on-sand effect, a slow recovery and a buoyant stock market, which offer little promise for long-term prosperity. Even the Fed’s own economists have expressed doubt about its ability to significantly influence employment, especially over longer periods of time.
Such doubt is well founded. Monetary policy is not an instrument for directly promoting economic growth. Rather, it is a business cycle stabilization tool. Excessive swings in the business cycle can negatively affect consumers’ decisions to spend and businesses’ decisions to invest to a degree, thereby restraining the rate of growth for periods of time. But, such instability is merely fluctuations about a long-term path of growth in output and incomes—the bottom-line determinant of increases in the standard of living. The central growth policy question therefore is what determines the long-term growth rate.
The core response comes from the realization that the weak rebound in employment and income is due to structural rather than cyclical problems, meaning that it has longer-term roots and will therefore be harder to fix. As demonstrated conclusively by many economic studies, the critical driver of structural economic health and hence long-term prosperity is productivity growth. Raising productivity enables sustained growth in consumption without rising prices.
Part of the problem is that we don’t seem to understand that globalization is the culprit. Other countries are making larger investments in productivity growth. Because their workers are on average paid less than American workers, our wage rates must fall or at a minimum cannot grow. In the absence of domestic investment in productivity, global wage arbitrage is constraining growth in workers’ incomes.
Attaining sustained productivity growth to achieve noninflationary output and income expansion requires a very different set of policy tools. First and foremost, investment in technology must be increased, as it is clearly the long-term driver of productivity. This means increasing research and development spending. However, the United States has steadily slipped in the national R&D intensity standings. We now rank ninth among industrialized nations.
Second, sustained investment in hardware and software is essential, as this is how most technology gets into economic use. In the last decade (2000-2009), this category of investment virtually dried up, with only a weak recovery so far in the current decade. We shouldn’t be surprised, given the lack of sustained tax incentives (including a weak and off-again, on-again R&D tax credit and bonus depreciation provision) and corporations’ preoccupation with manipulating their earnings statements. Deutsche Bank calculates that since the end of the last recession, S&P 500 companies have bought back $2.4 trillion of their stock. Doing so has artificially raised earnings, but it has also diverted funds from investment.
Third, aggressive programs are needed to raise labor skill levels so workers can operate more technologically intensive hardware and software. But, U.S. students spend fewer days in school per year than virtually all of our international competitors, and their performance on international standardized tests is mediocre at best. American CEOs are unanimous in complaining about the inadequacies of our educational system. Yet, we still debate whether or not a shortage of skilled workers exists. Traditional economists still argue that the price mechanism will bring forth the skills corporate America says it needs. What they are ignoring is the fact that education is a public good and therefore must be provided through public policy. Thus, if the skilled workers are not spurred by government policies, no wage is high enough.
When structural problems become sufficiently serious, countries often promote depreciation of their currency. This standard policy response is supposed to buy time to fix structural problems that are inhibiting productivity growth. The cost of currency depreciation is inflation due to higher import prices and hence a lowering of the standard of living. This is the price that has to be paid until restructuring is successful—if it is pursued. If not, then a permanent reduction in economic welfare is the result.
In this regard, it is unfortunate that the declining budget deficits have gone largely unnoticed. Fiscal policy is, like monetary policy, a business cycle stabilization tool in that the level of government spending can add or subtract demand stimulation. However, unlike monetary policy, it also has an investment component that has been rejected by conservatives and largely ignored by liberals. In a productivity-oriented growth policy, the investment component of fiscal policy (such as expanding funding for science and engineering research) will have to play an essential role. The nature of the modern technology-driven economy demands such.
The U.S. economy is not yet in the dire position of many other industrialized nations, such as those of southern Europe, in that we still have competitive industries and produce a lot of technology. Our currency has actually appreciated due to the economy’s modest recovery relative to the rest of the world and the fact that we currently have higher interest rates than most competing economies. But, the current negative effect of this trend on corporate profits is a warning of what is to come without a much greater emphasis on productivity growth.
The apostles of denial will point to our past performance as guaranteeing our competitiveness in the future. Unfortunately, it doesn’t work that way. For an economy of our size, current levels of investment are too little and too concentrated to yield the overall productivity growth needed to raise the standard of living going forward.