Research Topics

In this latest Strategic Analysis, the Institute’s Macro Modeling Team examines the current, anemic recovery of the US economy. The authors identify three structural obstacles—the weak performance of net exports, a prevailing fiscal conservatism, and high income inequality—that, in combination with continued household sector deleveraging, explain the recovery’s slow pace. Their baseline macro scenario shows that the Congressional Budget Office’s latest GDP growth projections require a rise in private sector spending in excess of income—the same unsustainable path that preceded both the 2001 recession and the Great Recession of 2007–9. To better understand the risks to the US economy, the authors also examine three alternative scenarios for the period 2015–18: a 1 percent reduction in the real GDP growth rate of US trading partners, a 25 percent appreciation of the dollar over the next four years, and the combined impact of both changes. All three scenarios show that further dollar appreciation and/or a growth slowdown in the trading partner economies will lead to an increase in the foreign deficit and a decrease in the projected growth rate, while heightening the need for private (and government) borrowing and adding to the economy’s fragility. 

The US economy has been expanding moderately since the official end of the Great Recession in 2009. The budget deficit has been steadily decreasing, inflation has remained in check, and the unemployment rate has fallen to 6.7 percent. The restrictive fiscal policy stance of the past three years has exerted a negative influence on aggregate demand and growth, which has been offset by rising domestic private demand; net exports have had only a negligible (positive) effect on growth.   As Wynne Godley noted in 1999, in the Strategic Analysis Seven Unsustainable Processes, if an economy faces sluggish net export demand and fiscal policy is restrictive, economic growth becomes dependent on the private sector’s continuing to spend in excess of its income. However, this continuous excess is not sustainable in the medium and long run. Therefore, if spending were to stop rising relative to income, without either fiscal relaxation or a sharp recovery in net exports, the impetus driving the expansion would evaporate and output could not grow fast enough to stop unemployment from rising. Moreover, because growth is so dependent on “rising private borrowing,” the real economy “is at the mercy of the stock market to an unusual extent.” As proved by the crisis of 2001 and the Great Recession of 2007–09, Godley’s analysis turned out to be correct.   Fifteen years later, the US economy appears to be going down the same road again. Postrecession, foreign demand is still weak and the government is maintaining its tight fiscal stance. Once again, the recovery predicted in the latest Congressional Budget Office report relies on excessive private sector borrowing, and once again, the recovery is at the mercy of the stock market. Given that the income distribution has worsened since the crisis—continuing a 35-year trend—the burden of indebtedness will again fall disproportionally on the middle class and the poor. In order for the CBO projections to materialize, households in the bottom 90 percent of the distribution would have to start accumulating debt again in line with the prerecession trend while the stock of debt of the top 10 percent remained at its present level. Clearly, this process is unsustainable. The United States now faces a choice between two undesirable outcomes: a prolonged period of low growth—secular stagnation—or a bubble-fueled expansion that will end with a serious financial and economic crisis. The only way out of this dilemma is a reversal of the trend toward greater income inequality.  

Though the economy appears to be gradually gaining momentum, broad measures indicate that 14.5 percent of the US labor force is unemployed or underemployed, not much below the 16.2 percent rate reached a full year ago. In this new report in our Strategic Analysis series, we first discuss several slow-moving factors that make it difficult to achieve a full and sustainable economic recovery: the gradual redistribution of income toward the wealthiest 1 percent of households; a failure to fully stabilize and reregulate finance; serious fiscal troubles for state and local governments; and detritus from the financial crisis that remains on household and corporate balance sheets. These factors contribute to a situation in which employment has not risen fast enough since the (supposed) end of the recession to significantly increase the employment-population ratio. Meanwhile, public investment at all levels of government fell from roughly 3.7 percent of GDP in 2008 to 3.2 percent in the fourth quarter of 2011, helping to explain the weak economic picture.

For this report, we use the Levy Institute macro model to simulate the economy under the following three scenarios: (1) a private borrowing scenario, in which we find the appropriate amount of private sector net borrowing/lending to achieve the path of employment growth projected under current policies by the Congressional Budget Office (CBO), in a report characterized by excessive optimism and a bias toward deficit reduction; (2) a more plausible scenario, in which we assume that the federal government extends certain key tax cuts and that household borrowing increases at a more reasonable rate than in the previous scenario; and (3) a fiscal stimulus scenario, in which we simulate the effects of a fully “paid for” 1 percent increase in government investment.

The results show the importance of debt accumulation as a consideration in macro policymaking. The first scenario reproduces the CBO’s relatively optimistic employment projections, but our results indicate that this private-sector-led growth scenario quickly brings household and business debt to new all-time highs as percentages of GDP. We note that the CBO makes its projections using an orthodox model with several common, but fundamental, flaws. This makes possible the agency’s result that current policies will reduce the unemployment rate without a run-up in the private sector’s debt—“business as usual,” in the words of our report’s title.

The policies weighed in the second scenario do not perform much better, despite a looser fiscal stance. Finally, our third scenario illustrates that a small, tax-financed increase in government investment could lower the unemployment rate significantly—by about one-half of 1 percent. A stimulus package of this size might be within the realm of political possibility at this juncture. However, our results lead us to surmise that it would take a much more substantial fiscal stimulus to reduce unemployment to a level that most policymakers would regard as acceptable.

The economic recovery plans currently under consideration by the United States and many other countries seem to be concentrated on the possibility of using expansionary fiscal and monetary policies alone. In a new Strategic Analysis, the Levy Institute’s Macro-Modeling Team argues that, however well coordinated, this approach will not be sufficient; what’s required, they say, is a worldwide recovery of output, combined with sustainable balances in international trade.