What Accounts for the Slow Growth of the Economy After the Recession? (PDF)

The U.S. economy has grown slowly since the deep recession in 2008 and 2009, which was triggered by a sharp drop in house prices and a subsequent financial crisis.

During the three years following the recession (that is, the third quarter of 2009 through the second quarter of 2012), the economy’s output grew at less than half the rate exhibited, on average, during other recoveries in the United States since the end of World War II.

All told, between the end of the recession and the second quarter of 2012, the cumulative rate of growth of real (inflation adjusted) gross domestic product (GDP) was nearly 9 percentage points below the average for previous recoveries. Researchers continue to grapple with understanding the roles that steep declines in house prices and financial crises play in slowing the growth of output.

In the current recovery, both potential GDP, a measure of the underlying productive capacity of the economy, and the ratio of real GDP to potential GDP have grown unusually slowly. Because potential GDP is an estimate of the amount of real GDP that corresponds to a high rate of use of labor and capital resources, it is not typically affected very much by the up-and-down cycles of the economy; in contrast, because the ratio of real GDP to potential GDP depends on the degree of the economy’s use of resources, it captures cyclical variations in real GDP around its potential level.

In the first 12 quarters after the last recession, both potential GDP and the ratio of real GDP to potential GDP grew at less than half the rate that occurred, on average, in the aftermath of other recessions since World War II .

Disaggregating the unusually slow growth in output since the end of the last recession, the Congressional Budget Office’s (CBO’s) analysis shows that that pace is mostly owing to slow growth in the underlying productive capacity of the economy and to a lesser extent, to slow growth in real output relative to that productive capacity.

Specifically, CBO estimates that about two-thirds of the difference between the growth in real GDP in the current recovery and the average for other recoveries can be attributed to sluggish growth in potential GDP.

That sluggish growth reflects weaker performance than occurred on average following other recessions by all three of the major determinants of potential GDP: potential employment (the number of employed workers, adjusted for variations over the business cycle); potential total factor productivity (average real output per unit of combined labor and capital services, adjusted for variations over the business cycle); and the productive services available from the capital stock in the economy.

Although some of the sluggishness of potential GDP since the end of the last recession can be traced to unusual factors in the current business cycle, much of it is the result of long term trends unrelated to the cycle, including the nation’s changing demographics.

The remaining one-third of the unusual slowness in the growth of real GDP can be explained by the slow pace of growth in the ratio of real GDP to potential GDP—which in CBO’s assessment, is attributable to a shortfall in the overall demand for goods and services in the economy.

The Effects of Recent Fiscal Policy Actions on the Economy

Federal lawmakers enacted a variety of tax and spending measures aimed at reducing the severity of the recession and spur the recovery. Some of those measures increased federal purchases, particularly in the first six quarters following the recession, when total federal purchases added more to the growth of real (inflation-adjusted) gross domestic product (GDP) than they had on average in previous recoveries.

Other measures provided a substantial indirect boost to the economy during the recession and recovery. Those measures included increasing transfers to people (such as unemployment benefits), lowering taxes, and providing support to the financial system. The key fiscal policy actions were these:

  • Direct fiscal stimulus came from the Economic Stimulus Act of 2008, which was enacted in February 2008, and the much larger American Recovery and Reinvestment Act of 2009 (ARRA), which was enacted in February 2009. The Economic Stimulus Act provided tax rebates to low- and middle-income taxpayers, tax incentives to stimulate business investment, and an increase in the limits imposed on mortgages eligible for purchase by Fannie Mae and Freddie Mac. ARRA authorized purchases of goods and services by the federal government, transfers to state and local governments (for spending on infrastructure and other purposes), payments to individuals, and temporary tax reductions for individuals and businesses (such as the Making Work Pay tax credit and favorable tax treatment of business investment). The Congressional Budget Office (CBO) estimates that ARRA raised real GDP by between 0.7 percent and 4.1 percent in 2010 and by smaller amounts in 2009 and more recently.
  • Other laws that were intended to have stimulative effects were ones that extended unemployment insurance benefits (which ARRA did as well); cut the payroll tax paid by employees in 2011 (which was later extended through 2012); provided credits for first-time home buyers (which were extended once by ARRA and again by the Worker, Home-ownership, and Business Assistance Act of 2009); and created the Car Allowance Rebate System (commonly referred to as “Cash for Clunkers”).
  • The Troubled Asset Relief Program (TARP) bolstered financial markets and institutions, largely by providing equity capital to banks and other financial firms.

In addition, fiscal stimulus without the need for new legislation came from the effect of the federal government’s so-called automatic stabilizers. Those stabilizers arise from the response of the federal tax system and social safety-net programs, such as the Supplemental Nutrition Assistance Program (formerly called the Food Stamp program), regular unemployment insurance benefits, and Medicaid.

The stabilizers automatically dampen swings in economic activity, by decreasing tax payments to the government and increasing benefit payments to households when economic activity slows and by having the opposite effect when economic activity picks up. For 2009 through 2011, federal fiscal support from the automatic stabilizers equaled about 2¼ percent to 2¾ percent of potential GDP, CBO estimates.

In CBO’s assessment, because the economy has been operating significantly below its potential level during the past few years, the boost to economic activity caused by fiscal policy actions was not significantly offset by a shift of resources away from production elsewhere in the economy—which is to say that little crowding out of production occurred.

However, when the economy is again operating close to its potential level, the increase in government borrowing that has resulted from the recent fiscal stimulus will tend to reduce the amount of funds available for private investment.

Therefore, policies that increase demand when the economy is weak often involve a trade-off between boosting economic output in the short run and reducing output in the long run, unless future policy changes are made to offset the additional accumulation of government debt.

Government Purchases

Relative to the average for past recoveries, purchases by federal, state, and local governments were more restrained in the 12 quarters after the end of the last recession (see Figure 3 on page 10).

Government purchases, which contribute directly to GDP, are outlays for goods and services, including compensation of government employees and investment in structures, equipment, and software. In contrast, other government spending (such as transfer payments to people) and taxes affect GDP indirectly through their influence on other components of output, such as consumer spending.

During and after the recession, federal policymakers enacted a variety of tax and spending measures that aimed to reduce the severity of the recession and aid the recovery. The positive impact of those fiscal policy actions on the level of output was larger late in the recession and early in the recovery than it was later in the recovery.

Purchases by State and Local Governments

Over the first 12 quarters following the last recession, weak growth in purchases by state and local governments slowed the growth of the ratio of real GDP to potential GDP by about 1 percentage point more than the average for previous recoveries (see Table 1 and Figure 3 on page 10). That weak growth in purchases stemmed equally from three sources.

Reductions in employment (of teachers and other personnel) account for a third of that weakness through lower payrolls; 12 quarters after the recession, growth in the number of workers employed by state and local governments was 12 percentage points lower than during the average recovery (see Figure 4 on page 11). Weakness in state and local governments’ purchases of goods and services from other sectors and a relatively slow pace of construction by those governments also each account for about a third of the overall weakness.

Most of the weakness in state and local governments’ purchases apart from their spending on construction can be traced to a below-average rebound in tax revenues and the need to balance general-fund budgets, but additional pressure came from below-average growth in federal grants.

The American Recovery and Reinvestment Act of 2009 (ARRA) authorized an increase in federal grants to states and localities through 2011; those grants helped support state and local purchases for a while, including in the final months of the recession, by raising the amount of assistance to states and localities above what it would have been otherwise.

However, the winding down, beginning in 2011, of payments from that increase in federal grants was most likely a drag on the rate of growth of state and local governments’ purchases last year and in the first half of this year.

In contrast, state and local governments’ construction spending was probably held back primarily by general budgetary pressures and by tight credit markets early in the recovery, because federal grants for capital projects in the current recovery have been in line with those during previous recoveries since 1959 (the first year for which such data are available).

Purchases by the Federal Government

Over the first 12 quarters following the recession, weak growth in purchases by the federal government slowed the growth of the ratio of real GDP to potential GDP by about threequarters of a percentage point compared with the average for previous recoveries (see Table 1 and Figure 3 on page 10).

Over the first half of that period, those purchases contributed more to economic growth (measured by growth of real GDP relative to potential GDP) than they did on average over the same period following other postwar recessions. Since the start of 2011, however, purchases by the federal government have provided less support, primarily as a result of weaker spending on national defense.

 As in the analysis of other sectors of the economy, the possibility of indirect effects complicates estimating federal purchases’ contribution to the growth of output since the trough of the recession. When an economy is operating near (or above) its potential level, higher government

spending can shift resources away from production in other sectors to government-funded projects. That indirect crowding-out effect means that increases in government spending may be offset by declines in purchases and investment elsewhere in the economy.

 However, by CBO’s estimates, that offset has been modest since the recession ended because of an economic environment in which unemployment has been high, a large amount of capital resources has gone unused, and interest rates have remained extraordinarily low.

Monetary Policy and the Slow Growth of Output

An important reason for the slow growth of the U.S. economy relative to its potential during this economic recovery is that the Federal Reserve’s ability to lower interest rates to stimulate economic activity has run into the limit that interest rates cannot be lower than zero. Moreover, the economy has been less responsive to a decline in interest rates in this recovery. Monetary policy has often spurred economic recoveries.

The Federal Reserve effectively sets the federal funds rate (the interest rate that financial institutions charge each other for overnight loans of their monetary reserves), which influences the demand for goods and services. The Federal Reserve usually can boost demand by reducing the federal funds rate, which typically lowers other interest rates, increases the prices of assets such as corporate equities, and lowers the exchange rate.

However, the Federal Reserve has been constrained in combating the recent recession. During that recession and early in the subsequent recovery, the historical relationships between the federal funds rate, economic activity, and the rate of inflation generally suggested that the federal funds rate would be less than zero.1 Because setting interest rates below zero is not possible, the Federal Reserve could only reduce the federal funds rate to near zero, where it has been since late 2008.

As a result, the Federal Reserve has used nontraditional policies, including large-scale purchases of securities issued by the Treasury and government sponsored enterprises, to push down longer-term interest rates on both Treasury borrowing and private-sector borrowing, such as mortgages. Those nontraditional policies noticeably reduced longer term interest rates, but they have not been powerful enough to spur strong economic growth.