Anatomy of the Current Recession
Not everyone has the stomach for perusing the national income and product accounts, but one who does can learn a great deal about what ails the present economy and about its prospects for returning to a healthier condition. (I draw the data I discuss here from Table B-2, “Real gross domestic product, 1960-2009,” in the statistical appendix that accompanies the 2010 report of the president’s council of economic advisers.)
We’ve all been told, of course, that the real gross domestic product has fallen from its peak in the second quarter of 2008. The data show a fall of nearly 4 percent by the second quarter of 2009. Although this drop bears no serious comparison with the precipitous decline of real GDP during the Great Depression—about 30 percent between 1929 and 1933—it has certainly entailed a great deal of difficulty and frustrated expectations in a situation where many people had made plans based on their anticipation of ongoing economic growth. Between the second quarter and the fourth quarter of 2009, real GDP grew by about 2 percent, making up for roughly half of the preceding decline.
To see why the recession has brought out the doomsayers in such great numbers during the past two years, notwithstanding the rather slight decline in national output, we must examine, among other things, the national product’s components. Doing so, we find, for example, that as usual in an economic slump, private consumption spending has held up much better than private investment spending: the former fell by less than 2 percent, and most of the decline was erased during the third and fourth quarters of 2009, so that by the final quarter of last year, real private consumption spending was less than 1 percent below its previous quarterly peak.
So, judging by what has happened to GDP and to private consumption, one might conclude that the recession has been only a minor dip—how much difference can it make in our style of life if our consumption falls by 2 percent for a short while?—and we might be tempted to conclude that getting out of the present troubles will be a task easily accomplished in the next few quarters.
Reaching such a conclusion, however, would be a mistake, because despite what the news media are always telling us about the preeminent importance of consumption spending in the determination of GDP, consumption does not drive genuine economic growth except in the very short run in a depressed economy. Real economic progress turns on a high rate of investment—primarily business purchases of structures, equipment, software, and additions to inventories—and on this front the news has been much bleaker and the prospects for quick recovery much less encouraging.
Gross private domestic investment peaked in 2006. Between the first quarter of that year and the second quarter of 2009, it fell by almost 34 percent. During the following two quarters, it rose by only 10 percent, so that late last year it was still (when measured at an annual rate) running about 29 percent below its level early in 2006. Such a huge shortfall in investment spending portends an extended period of slow economic growth in the next few years, and perhaps in an even longer run. Worn-out equipment, obsolete software, ill-maintained structures, and depleted inventories are not the stuff of which rapid, sustained economic growth is made.
The current investment drought does not simply reflect the housing bust consequent to the boom that drove residential investment to a peak in 2005. To be sure, real residential investment has fallen tremendously, by almost 53 percent between 2005 and 2009, with especially rapid declines during the past three years. Yet, real nonresidential investment also fell greatly last year, by 18 percent from its peak in 2008. Even real investment in equipment and software—a category only loosely connected to the housing boom and bust—declined last year by 17 percent, after occupying a high plateau during the preceding three years. Business firms have also fled from inventory investment, trimming their holdings by an unprecedented $125 billion in 2009, after lopping off $35 billion in 2008.
If real investment spending has taken a huge hit, however, federal government spending has raced ahead in high gear. Between 2007 and 2009, federal purchases of newly produced final goods and services—the federal government’s “contribution” to GDP—increased by more than 13 percent in constant dollars. Unfortunately, whereas private investment is the engine of economic growth, government spending (despite what generations of Keynesian economists have asserted) is the brake. Although increased government purchases by definition increase the measured national product, their substantive effect on the process of sustained economic growth is decidedly detrimental.
To understand this negative relationship, we need only to scrutinize how the federal government’s spending is determined, namely, by political processes devoid of economic rationality, and to examine the overwhelmingly adverse effect of government’s growth on the private economy’s functioning. In this light, we can appreciate that enhanced government spending does not actually bulk up the economy—it does not simply compensate for “leakages” from the circular flow of income generation, as the Keynesians imagine. Nor does it merely crowd out worthwhile private activity. Instead, it undercuts, penalizes, and distorts everything that private parties attempt to do to create genuine wealth. Beefed-up regulations, additional taxes, and government takeovers are the known killers of the economic growth process.
Much of the government’s “contribution” to GDP, of course, is pure waste, even if the recipients of the payments do nothing more to stand in the way of real progress: the government simply increases the compensation of its legions of drones and wreckers, or it spends money on items for which no private person, if he had any choice in the matter, would pay.
Worst of all, the investors’ famine and the government’s feast are not merely coincidental, but causally connected. The explosion of the federal government’s size, scope, and power since the middle of 2008 has created enormous uncertainties in the minds of investors. New taxes and higher rates of old taxes; potentially large burdens of compliance with new energy regulations and mandatory health-care expenses; new, intrinsically arbitrary government oversight of so-called systemic risks associated with any type of business—all of these unsettling possibilities and others of substantial significance must give pause to anyone considering a long-term investment, because any one of them has the potential to turn what seems to be a profitable investment into a big loser. In short, investors now face regime uncertainty to an extent that few have experienced in this country—to find anything comparable, one must go back to the 1930s and 1940s, when the menacing clouds of the New Deal and World War II darkened the economic horizon.
Unless the government acts soon to resolve the looming uncertainties about the half-dozen greatest threats of policy harm to business, investors will remain for the most part on the sideline, protecting their wealth in cash hoards and low-risk, low-return, short-term investments and consuming wealth that might otherwise have been invested. If this situation continues for several years longer, the U.S. economy may well suffer its second “lost decade” for much the same reason that it suffered its first during the 1930s.