Author: Eddlem, Thomas R
Date published: October 8, 2012
Journal code: NEAM
When President Obama submitted his first two budget proposals to Congress in early 2009 and 2010, he included assumptions that the recession would be followed by three years of economic growth approaching four percent per year.
The growth never materialized.
After shrinking in 2008 and 2009, the U.S. economy instead grew at an anemic 2.4 percent of gross domestic product (GDP) in 2010. Even weaker growth ensued in 201 1, just 1.8 percent of GDP, which has also been the rate of growth for the first two quarters of 2012. That's just a bit better than production needed to account for population growth and, obviously, not enough to bring unemployment levels below the eight-percent mark.
Obama's rosy economic projections of 2009 and 2010 were not pulled out of thin air. The White House's Office of Management and Budget had simply projected growth rates by compiling an average growth rate during post World War II recoveries after a recession. During the Reaganera recovery years, economic growth averaged 4.3 percent annually for seven years after a recession where unemployment had soared even higher than the highest levels of the current recession. What Obama projected was by no means unrealistic.
So what happened to the economic recovery this time?
There are competing schools of thought about why the economy failed to grow as forecast after the recession, each with mutually exclusive conclusions about what ought to be done.
Not Enough Demand
The establishment Keynesian school of economics - the dominant economic school of thought in government and academia for a generation - claims that government spending is needed to lift an economy out of a recession by stimulating reticent consumer demand. The key equation for Keynesians is the formula by the school's founding father, British economist John Maynard Keynes, for aggregate demand: C+I+G=Y
The formula attempts to extract the elements of demand for goods in an economy, and means this: C (consumption) plus I (investment) plus G (government spending) equals Y (total demand). Keynes posited that consumers trim back consumption spending in a recession, which leads to pull-backs by producers, which leads to more layoffs and another wave of reduced consumption by consumers. Keynes called this theoretical private-sector economic death spiral a "liquidity trap" because consumers hang onto their cash and withdraw from markets in a panic. Keynes said that in order to stop a liquidity trap, government needs to step in with higher spending - boosting total demand and restoring consumer confidence and consumption spending.
Yale University Professor Robert Shiller - an economist who was one of the few Keynesians to predict the housing bubble and bust of 2002-2008 - called massive government "stimulus" spending during the recession a grand Keynesian "experiment." He told CNBC reporters from the Davos Economic Summit on January 28, 2010, "The recent recovery was a wonderful experiment in Keynesian economics, but there isn't uniform support for these things. One thing is that people start to worry about the debt incurred and that can cause a backlash - a political backlash - that would stop any further such efforts, even if they are still needed." Shiller also tentatively projected for his audience that there would be about five or more years of sluggish growth, rather than a robust recovery. "I just don't see this going away soon. I'm not saying we're in for a depression." Shiller made this prediction because he believed that the positive effects he attributed to government spending increases would be offset by fiscal austerity measures the following years.
Shiller's fear was the opposite of the Austrian free-market school of economics, as Shiller wanted to maintain government spending increases for several years into the recovery in order to make it a robust - rather than a lackluster - recovery. He also wanted to continue Federal Reserve Bank suppression of interest rates to induce consumers to borrow and spend more.
Too Much Debt; Too Little Savings
The Austrian free-market school of economics has counseled that any stimulus by means of government spending is like a narcotic drug addiction: It feels good during the "high" period, but it makes coming off the drugs harder, with larger and larger amounts of drugs needed down the line just to feel normal.
The New American analyzed this "wonderful experiment in Keynesian economics" to see if the lackluster growth following the latest recession can be attributed to too much government debt (as the Austrians say) or to a quick end to the experiment by fiscal austerity and too much government belt-tightening (as the Keynesians say), using proofs in a manner typical of Keynesians. The Keynesian school analyzes macroeconomic data and believes proofs can be made in the same sense as a scientist can prove a thesis in a laboratory using the scientific method (induction). The Austrian school, on the other hand, argues that proofs in a scientific sense cannot be obtained in a large, complex economy with billions of variables. They hold that it is impossible in a large economy to isolate variables in the same way a scientist can isolate them in laboratory test tubes. Austrians hold that the best way to test a thesis is to use the logic of deduction from universally held truths.
Using deduction, Austrians would affirm the economic drag created by high government debt: In 201 1, the United States government spent some $454 billion to pay interest on the national debt, about three percent of the nation's gross domestic product. None of this money was used to pave roads, build housing, or create businesses. One might expect that this money did not contribute to economic growth in any substantial way.
But even if one accepts the Austrian school argument that an absolute proof using the scientific method is not possible because of the many variables in a modern global economy composed of billions of actors, analysts can still look at the global macroeconomic data and find a statistical correlation and conclude which thesis appears closer to finding the cause.
Analyzing the "Wonderful Experiment"
One of the easiest ways to measure the results from the "wonderful experiment in Keynesian economics" is to look at the growth data from developed nations before, during, and after the Great Recession and match it up to government spending data. The International Monetary Fund maintains a database of this information on its website, where one can track the economic progress of the 34 "developed nations" according to government spending and a variety of economic factors from the beginning of the slowdown in 2007 through the current year. Keynesian theory claims massive infusions of government spending were needed in 2008 and 2009 to compensate for slackening aggregate demand as a result of private investors pulling funds out (in order to avoid a liquidity trap).
The best measure of the effectiveness of government stimulus spending is to take gross spending and extract a percentage change from the previous year. Because all developed governments have total government spending between 36 and 50 percent of GDP, not an exceptionally wide margin, the proportion of spending increase in each country would have fairly close to the same stimulus impact if year-over-year increases/decreases in government spending are measured.
Keynesians would be fairly pleased by recession-era data. The data for GDP numbers in developed nations that engaged in significantly higher government spending during the recession years of 2008-09 do show smaller economic contraction, though the trendline is less pronounced in 2009. (See chart #1.) The recovery-era data is less pleasing for Keynesians. Increased goveminent spending had no measurable benefit on the economy of the 34 developed nations. (See chart #2.) The IMF data for increased government "stimulus" spending during the recovery years of 2010-1 1 suggests that Shiller's worry about government austerity - that government belt tightening would impede recovery - in 2010 may have been misplaced.
The overall six-year 2007-12 trendline (See chart #5) does show a modest overall increase in GDP for nations during years governments increased spending, though the trend requires a massive 20-percent increase in year-over-year government spending in order to increase GDP growth by one percent in any given year. A 20-percent real increase in government spending in a single year is a massive change - in a recession, this would be an increase of about one-tenth of everything produced in the country - and it's a spending increase that creates concerns about long-term debt accumulation if it is not accompanied by commensurate tax increases.
The IMF data charting a mild stimulative impact of more government spending appears to be solid. Statistical outliers in the data do not measurably change the trendline. Statistical outliers on charts #1 and #2 include massive spending increases by Hong Kong and Singapore in 2008, which experienced lower than average contractions, and in 2009 by a huge one-year economic contraction in Estonia, which had cut 1 .4 percent of government spending that year. Each of these three nations has had the strongest recovery since 2009, along with Taiwan (which engaged in modest government spending increases during 200809). Deleting these three statistical outliers from the data would not significantly change the trendline. Neither would excluding data from collapsing economies such as Ireland, Greece, and Iceland. These nations had only cut government spending because they had no other choice; they were unable to borrow any more money from lenders in global bond markets. One might argue that including data from national economies already in a state of collapse is not a fair measure of the success of government stimulus for generally successful economies, such as the United States. But the question is academic, as these three nations did not measurably change the overall 2007-12 trendline.
The data demonstrate that at least some temporary economic progress was made with government stimulus during the recession, as the Keynesians argue, but Austrians argue that the short-term benefit was far outweighed by burgeoning national debt and lowered savings rates that have stunted the recovery. And the data demonstrating the Austrian argument is even stronger (see chart #3). In every year from 2007-12, nations carrying a higher debt level as a percentage of GDP experienced slower economic growth. Nations that carry low debt-to-GDP ratios include the Scandinavian nations, Estonia, Hong Kong, Australia, and New Zealand. Each of these reliably achieved economic growth above the developed world median level of GDP growth. Australia had the lowest debt ratio of all developed nations, and was the only developed nation not to post GDP shrinkage for either 2008 or 2009.
Using growth and debt figures from the IMF on all 34 developed countries from 2007-12 (chart #3), one can conclude that for every 50 percent of GDP added in government debt, nations during 20071 2 experienced a subtraction of a full one percent in GDP growth every year. The overall IMF database, which includes data back to 1980, charts a similar trend. The average decline in GDP growth for 1980-2012 when government debt hit 50 percent of GDP was about three-quarters of a percent annually. And 50 percent of GDP happens to be the same amoimt of debt added in the United States during the combined time periods of the George W. Bush and Obama administrations.
In 1982 - when the Reagan-era recovery began - the national debt-to-GDP ratio was 46 percent, half the level when the current recovery began in 2009. And while many will be quick to blame President Obama for his big-spending ways, it's important to note that half of the debt piled up before the recovery came from Congresses during the Bush administration. (Presidents can't spend money. Only Congress can appropriate funds, though the president can make recommendations.) This debt was piled up in a bipartisan fashion, by Republican Congresses before 2007, by Democratic Congresses from 2007-2010, and by a split Congress (Republican House and Democratic Senate) since 2011.
But the "debt explanation" of why the United States has had such poor economic growth contains one key flaw: Several nations carrying large debt reliably beat the expected trendline on chart #3, even though most did not grow as fast as most low-debt nations. Singapore and Japan carry massive debt, and beat (or bent) the trendline every time. Singapore maintains a very high national debtto-GDP per capita, nearly 100 percent of GDP, though it's less than Japan, Greece, Portugal, Ireland, the United States, Belgium, and Italy. Yet its economy has one of the top growth rates in the world. Japan has endured abysmal growth rates for two decades, but it nevertheless bent the expected trendline upward for its massive national debt of 230 percent of GDP (more than twice the U.S. figure). Japan never scored below the trendline and had two years of growth significantly above it.
Austrian school adherents have an explanation for why the recovery has been so lackluster for some, and relatively robust for nations such as Singapore, Hong Kong, Taiwan, and Sweden: High national savings rates. Japan's National Savings Rate has been reduced in recent years because of government deficit spending, but personal savings rates have nevertheless kept the national rate above 20 percent. That's almost double the U.S. rate, which is in the 11-13 percent range.
It's not spending and demand that create economic growth, Austrian school adherents argue. Rather, it's private-sector savings and investment that create growth. Austrian school theorists are quick to criticize interest rate suppression by the Federal Reserve Bank in the United States as discouraging savings (by offering a lower rate of return for investments) and encouraging spending and borrowing (by lowering the price of borrowing). This is one of the key differences between the Austrian school of economics and the dominant Keynesians, as the latter argue monetary stimulus in the form of interest rate suppression is needed to stimulate demand in a recession.
The Austrian school thesis can be measured against IMF data on "National Savings Rates," which essentially measure national savings as a function of national income (GDP) minus consumption and government spending (the figure sometimes also includes some government "savings"). The National Savings Rate also serves as an antithesis of the Keynesian argument that high private savings rates need government spending increases during recessions in order to overcome a liquidity trap. In Keynesian terms, the classical aggregate demand formula of Y=C+I+G is reversed to this: Savings=I=Y-(C+G). If Keynesian theory is correct, then nations with high savings rates (and therefore, low consumption) would have lower growth rates in recessions. If the Austrian school is right, then nations with high investment/savings rates would be able to liquidate bad investments in a recession and recover more quickly.
The data demonstrate a correlation between high savings and high economic growth, the strongest correlation of data in available IMF data fields. The data seriously undercut the Keynesian principle of aggregate demand being the key in an economy. In every year of the 2007-12 period measured (as well as the overall 1980-2012 IMF dataset), nations with high savings rates had significantly higher economic growth. That trend was especially strong in recovery years. The Austrian school would claim that these high savings rates in Singapore and Hong Kong - the two city-states have the highest savings rates in the developed world - are the cause for stronger-than-expected economic growth, not government stimulus. Keynesians would likely counter that the massive government spending increases brought confidence back into the markets of these Asian city-states and prevented a liquidity trap. But Keynesian theory lacks a full explanation for the overall poor economic recovery.
Austrian school theory also fits neatly into the results of more robust recovery during other recoveries, such as the Reagan-era recovery. From 1980-84, the U.S. Gross National Savings rate hovered in the 1 7-20 percent range, whereas over the last three years it has hovered in the 11-13 percent range.
It should hardly be surprising that savings rates in the United States were higher in the early 1 980s. Federal Reserve Bank under Chairman Paul Volcker had hiked interest rates up to record highs during the Reagan recovery as part of an antiinflationary campaign. Federal Reserve discount interest rates for banks floated between 8-12 percent in 1982-83, essentially punishing borrowers and rewarding savers, in contrast with the 0.00-0.25 percent rate sought by the Fed during the current recession.
The aggregate trend lines for 198020 1 2 from developed nations demonstrate an additional percent of GDP growth per year for every 8.8-percent increase in national savings rate (after controlling for government debt levels), and 8.8 percent is just a bit more than the actual reduction in U.S. national savings rates between the 1982-83 and 2008-09 recessions. Austrian school theorists would also not be surprised that Greece, which has the lowest savings rate among industrialized nations, would never rise above the debt trend line while Japan - with almost double the U.S. savings rate - would have higher than expected growth based upon its level of government debt.
The recovery data for Keynesian "stimulus" economic theory have a dubious correlation with economic growth (contrast the results measuring demand in charts #4 and #5), and requires an extraordinary change in the level of government for moderate results. But Austrian school theory has a perfect correlation with growth in both the recession and recovery periods. While there is a slight overall trendline higher economic growth in nations governments increase spending, thing that buttresses the Keynesian argument, Keynesian theory is seriously dercut by stronger recoveries in national economies with higher national savings rates (thus, lower aggregate demand). mixed results for Keynesian theory appear to support the Austrian school view that the variables cannot be isolated an absolute proof using the logic of tion (scientific method).
Using charts #3 and #4, one can conclude that the current United States economy would lose nearly two full percentage points of growth every year when compared with the 1982-83 recovery, about one percent based upon the added level of government debt and another percent based upon lowered savings rates. Indeed, adding two full percentage points to each of the years of the current recovery would bring it roughly up to the levels projected by President Obama in his first two budgets, i.e., from 2.4 percent in 2010 to 4.4 percent, and from 1 .8 percent in 201 1 to 3.8 percent. The numbers also correspond fairly closely to the growth rates during the Reagan-era recovery.
So who killed the recovery?
While there is no proof in a scientific sense of what caused it, the data are consistent with the following explanation: The big-spending Congress, which piled on debt, and the Federal Reserve Bank's suppression of interest rates, which discouraged savings and investment, have been, roughly speaking, equally responsible for the weak recovery.