Why the Economic Recovery Is Feeble

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Federal Reserve Chairman Ben Bernanke last week became the latest economist to ask why the current economic recovery has been so weak. The question has inspired a cottage industry of studies, papers and speeches with often-esoteric and murky theories. The explanation is actually straightforward: The financial crisis and Great Recession scared the wits out of most Americans - not just consumers but also corporate managers, bankers and small-business owners. They are reacting accordingly. They're cautious, risk-averse and defensive. They're spending less and saving more.

The recovery's languor is striking. Bernanke, speaking to the New York Economic Club, noted that the economy's annual growth rate had averaged only about 2 percent since the recession officially ended in mid-2009. By contrast, the average growth rate of post-World War II recoveries at a similar stage is almost 4.5 percent. This means the economy is producing about $1.4 trillion less of everything, from Big Macs to cars, than it would if we'd had an average recovery.

To be sure, the recession's severity stemmed from the housing bubble and the damage to homeowners and financial institutions. From the third quarter of 2007 to the first quarter of 2009, household wealth (net worth) fell $16 trillion, reflecting a collapse of home and stock prices. In the same period, the number of unemployed workers jumped by 6.4 million. People - again, not merely consumers but also business managers, bankers and others - were shell-shocked. To conserve cash, consumers curbed spending; businesses did likewise by canceling investment projects, firing and not hiring.

But remember: This was more than three years ago. Typically after a recession hits bottom, there's a period of above-average growth. Excesses (too many houses or dot-com start-ups) are cured by fire sales or bankruptcies. Pent-up demand or government "stimulus" policies spur spending. Surviving businesses begin to hire to meet added sales. Confidence revives. Recoveries become self-sustaining.

In today's recovery, this recuperation has been partial. One theory is that recessions accompanied by a financial crisis are harsher and longer. To repay debts, borrowers reduce spending. Facing bad loans, lenders lend less or go bankrupt. But again: Time has passed. Many adjustments have occurred. Household debt payments (interest plus principal) as a share of disposable income have dropped to 1993 levels, says the Fed. Banks have raised billions of capital to offset loan losses.

Still, the recovery stumbles.

The residue of fear and anxiety is far greater than after other postwar recessions, with the possible exception of the deep 1981-82 downturn. Bad things happened that were not supposed to happen. We were supposed to be immune from major financial crises or anything resembling the Great Depression. Economic progress - the advance of knowledge and policymaking - had cured us of these afflictions. Not so, it turns out.

If the impossible happened once, it could happen again. Better to be cautious and prepared. This was the lesson.

It's been reinforced by other events. Since late 2008, the federal government has run $5 trillion of deficits; the Federal Reserve has held short-term interest rates at near zero and has, through purchases of bonds, pumped more than $2 trillion into the economy. Economists argue whether more could have been done. But to typical Americans, these sums seem huge and have produced, at best, only modest benefits. The tools of economic control don't work so well. It's hard to avoid a sneaking suspicion that the people at the top don't know what they're doing.

And then there's Europe. As Bernanke noted, its budgetary crisis was "not anticipated." A decade ago, hardly anyone thought that advanced nations might default on their government debt. Now the possibility is openly discussed. Mark this as another instance of the "impossible" happening and confounding confidence.

We have gone from "irrational exuberance" to chastened restraint. The first fueled borrowing and spending, while the second - the past's costly surprises and the future's unknowns - discourages the same. Companies have $1.7 trillion in spare cash, reflecting a reluctance to invest and to hire. The Fed's low interest rates and plunging home prices (down about a third nationally) might have triggered a strong housing revival. But that's been frustrated by lenders maintaining "tight terms and conditions on mortgage loans, even for potential borrowers with relatively good credit," Bernanke complained. Consumer optimism has improved but remains at low levels. Savings rates could rise.

All this affects policy. President Obama's anti-business rhetoric and the complexities of Obamacare may also have weakened confidence. But in the election, voters gave him a pass on the economy, blaming mainly his predecessor. Still, Obama knows he cannot escape responsibility forever. Avoiding the "fiscal cliff" and doing so in ways that build Americans' faith in the future serve almost everyone's interest. Psychology matters.

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