During the past several weeks we have been discussing the appropriate roles the government plays in the economy. Why has this particular topic been chosen for a multi-month miniseries? The U.S. economy is performing well below its potential, largely as a result of the policies chosen in our national and state capitals.
To illustrate the issue at hand, consider two graphs which were constructed using the wonderful FRED website from the Federal Reserve Economic Database. The first of these compares the actual Gross Domestic Product to the potential Gross Domestic Product (aka the production possibility frontier) since 1970.
The grey regions represent recessions as defined by the private, nonprofit, nonpartisan National Bureau of Economic Research.
Notice the pattern. Each time the economy goes into recession, actual economic performance, as measured by GDP, drops below potential GDP. After a time, the economy recovers and continues to perform near full capacity until the next downturn.
Occasionally, as happened in the mid to late 1990s, the economy actually performs above potential. Such can happen for a brief period of time, but it is inconsistent in the long run. This is analogous to an employee who works 30 overtime hours per week. He can do it for a while, but eventually he must go back to a more reasonable balance of work and leisure.
We also point out that, during times of recession and recovery, the area between the potential GDP and actual GDP represents the shortfall of output we might have enjoyed if the economy had maintained full employment.
Certainly the most glaring aspect of this chart is the last five years. In 2008 and 2009 we suffered a huge drop in output. Yet, after half a decade, we still have not brought the economy back up to its potential. Our economy is running a parallel course several percentage points below our obtainable output. We are foregoing enormous amounts of income. Why? A glance at another graph sheds light on this subject.
Our second chart shows how much government spending has contributed to economic growth. For example, if total GDP growth, for a particular year, is three percent, and the government’s contribution to that growth was half, then the graph will show 1.5 percent for that year.
It is quite apparent that since the end of the Great Recession of 2009, the government sector has been a net drag on the economy. Legislated spending by the public sector has been reduced at the very time when public spending has been needed most.
Put another way, without the production of our public goods and services, including infrastructure projects, education, and so forth, it has been impossible for the economy to climb back to its production possibility frontier.
Why have we chosen to shrink the government at the very time we should have been expanding it? One answer is long-term memory loss. We tried the same policy during the Great Depression. It did not work then. It does not work now. We forgot.
To be fair, when times are tough it seems prudent to retrench. Consider the most recent experience. By early 2009, housing prices and the stock market had crashed. People felt much poorer than a year earlier.
During times like that, it seems foolhardy to embark on a government spending spree. Or does it? Households and businesses respond to the drop in housing and share prices by cutting back on spending. They do this because they feel poorer.
But are we poorer when a housing bubble or an equity bubble bursts? Is it possible that tough times are more imagined than real? We will examine this next week.
(Marcus Hutchins, MA, M. Phil, Economics, Columbia University, NYC, is a former economist, treasury bond arbitrage trader and hedge fund manager. He retired to Southport in 1997 where he resides with his wife Andrea and his youngest daughter Abbey. He welcomes feedback at coastaleconomist@me.com.)
