August 14, 2022

Economix: What’s a Crisis and What Isn’t

Today's Economist

Laura D’Andrea Tyson is a professor at the Haas School of Business at the University of California, Berkeley, and served as chairwoman of the Council of Economic Advisers under President Clinton.

Long term, the United States faces a fiscal challenge that must be tackled –- but it is not an immediate fiscal emergency. In the labor market, though, there is an immediate crisis, the worst since the Great Depression.

According to the latest estimates from the Congressional Budget Office, if current fiscal policies are maintained, federal debt held by the public could rise to an unprecedented 187 percent of gross domestic product in 2035 from 62 percent of gross domestic product at the end of 2010.

This is neither a desirable nor a sustainable outcome. Long before we got there, the United States would lose the confidence of investors, igniting a spike in interest rates, a collapse of the dollar, a global financial crisis and a devastating recession.

But with substantial excess capacity in the economy, there is no evidence that the federal deficit is driving up interest rates and crowding out private spending. What’s slowing the pace of recovery is not too much government borrowing but too little private spending.

Nor are there symptoms of an imminent sovereign debt crisis facing the American government over the next few years. Rather, worries about slower growth in the United States, along with a flight to safe assets and a reduction in risk appetite by global investors, have kept the federal government’s borrowing rates near historic lows.

And that’s despite threats by irresponsible members of Congress to initiate a default on the government’s debt by failing to pass an increase in the debt limit.

In the labor market, the situation is dire. Almost 14 million people –- 9.1 percent of the labor force –- were unemployed in May. About 45 percent of those had been unemployed for 27 weeks or more, according to the Bureau of Labor Statistics. Another 8.5 million part-time workers wanted but could not find full-time jobs; an additional 2.2 million dropped out of the labor force because they could not find work.

During the last five years, the percentage of the population working has fallen to 58 percent from 63 percent, reducing the number of Americans with jobs by 10 million.

The economic and human costs associated with the jobs crisis are staggering. An extended period of unemployment means lower earnings: workers who return after long-term unemployment earn 20 percent less over the next 15 to 20 years than a worker who was continuously employed.

The longer workers are unemployed the more likely they are to lose their skills and drop out of the labor force. And the longer workers are unemployed, the more likely they are to lose their homes, their health and their marriages –- and the more likely their children will grow up in poverty –- with adverse implications for their health, education, and future incomes.

The primary cause of the jobs crisis is a lack of demand, the same problem that bedeviled the economy in the 1930s. Consumers, long the primary engine of economic growth in the United States, are in the midst of an unprecedented retrenchment.

High debt levels, falling housing prices, a lack of employment opportunities and wage stagnation are forcing people to curb their spending, pay down their debt and increase their saving. In the 13 quarters since the beginning of 2008, the annual growth of real consumption, which still accounts for about 70 percent of gross domestic product in the United States, averaged just 0.5 percent. Not since the end of World War II has consumption been this weak for this long.

Speaker John A. Boehner and the Republican majority in the House say the way to address the immediate jobs crisis and the long-term fiscal challenge is to make deep cuts in federal spending. Indeed, a recent study by the Republicans on the Joint Economic Committee concluded that “quick, decisive government spending reductions” can promote growth and jobs in the short term.

But the overwhelming evidence suggests the opposite: when the economy has excess capacity, high unemployment and weak private demand, cuts in government spending reduce growth and eliminate jobs.

On this point, there is widespread agreement among experts. Ben Bernanke, chairman of the Federal Reserve, recently warned that sudden fiscal contraction might put the still fragile recovery at risk. The June report from the C.B.O. contains a similar warning. Even William Gross of Pimco, a vocal critic of the long-term fiscal position of the government, cautions that a move toward fiscal balance, if implemented too quickly, could “stultify economic growth.”

As Simon Johnson noted in his recent Economix post, fiscal contractions are expansionary only under special conditions. None of these apply to the United States today.

So what should policy makers do? They should pair fiscal measures aimed at job creation now with a credible plan to reduce the deficit gradually –- and pass both at once, as a package. Approving a deficit-reduction plan but deferring its starting date until the economy is near full employment will cut the odds that immediate contraction will tip the faltering economy back into recession.

Indeed, passage of such a package could bolster growth by easing investor concerns about future deficits, reducing long-term interest rates and strengthening consumer and business confidence.

There is strong bipartisan support among budget negotiators in Washington for an enforceable debt target as an essential component of a credible deficit-reduction plan. Breaching the target would lead to automatic changes in spending and revenues. I believe we should pair an unemployment-rate target with a debt target. The unemployment-rate target would postpone significant spending cuts or revenue increases to achieve the debt target until the economy is closer to full employment.

Most economists believe that full employment for the American economy implies a structural unemployment rate of 5 to 6 percent. The unemployment-rate target should be set within that range. Current forecasts by the C.B.O., the Office of Management and Budget, the Hamilton Project and most private-sector economists predict that this target will not be achieved until 2015 or later. That’s when serious actions to narrow the long-run fiscal gap would begin to take effect.

Can we afford to defer such actions until the economy is much closer to full employment? Yes.

As the economy recovers and temporary fiscal stimulus measures are phased out, the deficit as a share of gross domestic product is expected to decline markedly during the next few years. Extending some measures enacted at the end of 2010 –- the payroll tax cut for employees, the capital investment expensing deduction and long-term unemployment benefits –- would add little to the long-run fiscal gap and would boost the flagging recovery.

Given the magnitude of the jobs crisis, we should go further by cutting payroll taxes for employers on new hires, including all hires by new firms. David Leonhardt, a columnist at The New York Times; Michael Greenstone, an economics professor at the Massachusetts Institute of Technology; and Robert H. Frank, an economics professor at Cornell, have recently proposed this approach. Mr. Frank estimated that eliminating the employer payroll tax on new hires could result in more than five million new jobs. A cut in payroll taxes should be maintained until the unemployment rate target is reached.

As long as there is considerable slack in the economy and inflation remains low, the government should be able to finance targeted fiscal measures for job creation at reasonable interest rates, provided such measures are paired with a credible and enforceable deficit reduction plan. And provided that gamesmanship and blackmailing tactics over the debt limit do not undermine the creditworthiness of the United States on global markets.

Painful choices about how to close the long-run fiscal gap –- primarily the result of imprudent fiscal decisions before the Great Recession, escalating health-care costs and an aging population –- must be shaped now and enacted promptly over many years once the economy has recovered.

But in the next few years, the priorities of fiscal policy should be growth and jobs.

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