Not catching up

Not catching up

This is not a happy post.

Each year the federal budget cycle begins with release of the baseline from the Congressional Budget Office in a document titled The Economic and Budget Outlook. If you want to learn more about economic and fiscal policy I recommend you read carefully at least CBO’s short summary.

My former White House colleague Charles Blahous wrote a great piece that highlighted ten fiscal policy lessons you should draw from CBO’s latest baseline report. With this post I’d like to look at one important macroeconomic graph from that same report.

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This graph compares actual GDP with what GDP would be “if everyone were working,” a rough description of what the economists call potential GDP. They estimate the lowest unemployment rate that they think would be consistent with inflation not accelerating. CBO thinks this number is 5.5%. They then estimate what economic output would be if we were at 5.5% unemployment rather than where we are, which is now 7.9%.

The gap between the light blue (actual GDP) and dark blue (potential GDP) lines above therefore represents an estimate of the output lost due to high unemployment. To the left of the dotted line that output gap is in the past and cannot be recovered. To the right of the dotted line we see CBO’s projections for actual and potential GDP in the future. We want actual GDP to converge with potential GDP, to “close the gap” quickly.

Now let’s zoom out and look at a similar historical graph measured in decades rather than years.

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From this graph we can see that in the long run, actual GDP tracks closely with potential GDP, and that the recent output gap is quite large in comparison.

Let’s zoom back in and examine the recent past, the left half of CBO’s graph.

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The downward sloping part of the light blue line is the recent recession, also marked by the vertical white stripe. If you look closely you can see actual GDP flattening out in early 2008 as potential GDP continues to rise. Actual GDP then plummets as the financial shock hits in the second half of that year. The recession ended and the recovery began where the line started sloping upward in mid 2009.

In trying to frame this story positively President Obama draws your attention to the fairly steady growth of actual (real) GDP since the recession ended, the upward slope of the light blue line from mid 2009. This graph also shows that in recent years actual GDP had been growing at roughly the same rate as potential GDP. Because the light blue and dark blue lines have almost the the same slope, the distance between them is almost as large now as it was when the recession ended. So while the President is right that the economy has been growing for 3+ years, the output gap is almost the same size as it was in mid 2009. We’re not catching up.

Here is how CBO describes it.

By CBO’s estimates, in the fourth quarter of 2012, real GDP was about 5½ percent below its potential level. That gap was only modestly smaller than the gap between actual and potential GDP that existed at the end of the recession because the growth of output since then has been only slightly greater than the growth of potential output.

To close the output gap we need much faster short-term economic growth than we have had over the past three and a half years. We need the light blue line to slope sharply upwards until it meets up with the dark blue line.

Now let’s turn to CBO’s projection for the future. I’ll hide the left half of the graph this time.

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Now we can see more closely that CBO’s GDP projection has three significant features:

  1. CBO projects that real GDP will continue to grow only as fast as potential GDP this year;
  2. They then project that growth will accelerate; but
  3. They project that the output gap won’t close until the end of 2017, almost five years from now.

Attaching numbers to this, CBO projects real GDP will grow 1.4 percent in 2013, 3.4 percent in 2014, and 3.6 percent per year from 2015-2017, reaching potential GDP at the end of 2017.

This translates into their (un)employment projections as well. CBO projects an 8.0% unemployment rate in the fourth quarter of this year and a 7.6% rate at the end of 2014, only three-tenths of a percentage point below where we are now. They then project that the unemployment rate will decline to reach full employment by the end of 2017.

On our current path CBO projects we won’t reach full employment for almost five more years.

CBO also estimated the total size of the output gap and it’s depressing:

With such a large gap between actual and potential GDP persisting for so long, CBO projects that the total loss of output, relative to the economy’s potential, between 2007 and 2017 will be equivalent to nearly half of the output that the United States produced last year.

You may have noticed that I have avoided discussion (here) of why the economy has grown so slowly, how much of that is because of or in spite of policy decisions, and why it’s projected to continue to do so for the next year. That’s where the food fight begins, including the debate about whether and how much the 2009 fiscal stimulus increased growth, and the debate about how much of slow future growth is because of business uncertainty about the economy, about drags from policy and regulation, and about allowing more time for balance sheet repair after the financial shock of 2008.

Those are incredibly important debates but today I just want to highlight the basic historic facts and a mainstream projection from an unbiased source. On our current policy path CBO projects continued slow growth for 2013 and a gradual acceleration after that, returning the U.S. economy to full capacity output by the end of 2017. That projection excludes:

  • the downside risk to growth from policy shocks like further tax increases proposed by the President, repeated unresolved fiscal conflicts that exacerbate business uncertainty, and additional regulatory burdens rumored to be coming from HHS, IRS, EPA and financial regulators; and
  • the downside risk to growth from possible external shocks from a possible Middle East crisis or a sudden unraveling of Europe’s financial system.

I told you this wasn’t a happy post.

Summary

  • While the U.S. economy has been growing fairly steadily since the recession ended in mid 2009, it has been doing so far more slowly than we need. Actual growth has been just sufficient to keep up with growth in our national economic capacity.
  • CBO projects that 2013 will be yet another year of slow growth with acceleration beginning in 2014. They project we won’t reach full employment until the end of 2017, almost five years from now.
  • CBO estimates that the total lost economic output over the decade will be equal to the entire U.S. economic output for half of last year.

10 responses

  1. Keith, I am curious as to what exactly will cause the acceleration of the economy in 2014? It certainly won’t be the full implentation of Obamacare! Thanks

  2. I find it interesting that the economy won’t fully catch up until Obama is out of office. There are so many other variables, as you mentioned, that could affect the recovery. Let’s hope better choices are made sooner.

  3. The CBO uses an umemployment rate that seems to ignore work force participation and underemployment (i.e., part timers who want a full time job but can’t find one. So, it seems to me that “potential GDP” with not just 5.5% unemployment, but with a 66% or 67% workforce participation, should be even higher than what is shown on the CBO graph.

    • Actually, they might not assume that. I was oversimplifying in this post, and I don’t know what they assume for labor force participation when they calculate potential GDP. Great observation.

  4. Pingback: Links for 2-13-2013 | Karl Heubaum

  5. Why was the growth rate so bad during the Bush years despite the amazing SUPERPOWER of regressive tax cuts? Why would things be any different when conservatives get their favored policies? Why have all the wage gains gone to the upper class? What will conservatives do about it? Why is labor’s share of the national income at an all-time low and collapsing? Do conservatives care?

    These are the questions Conservatives need to answer and come up with realistic answers for if they want anychance of getting the support of the middle class.

  6. The CBO projections should not be taken too seriously, but I suppose it’s nearly the best we’ve got.

    There are a number of factors that would have a (negative) effect on the CBO projections and I think Hennessey, while he lists a few, has left out one of the major ones. I’ve read the CBO report and found only passing reference to monetary policy. The FOMC has indicated that its highly accommodative stance will end (and possibly start to be reversed) on the earlier of 1) unemployment rate reaching 6.5 percent (presumably irrespective of participation rate); or 2) inflation exceeding 2 percent.

    The CBO expects (see Table B-1) the unemployment rate to get at or below 6.5 percent sometime in 2016. Thus, *before* we reach “full employment” as the CBO defines it at 5.5 percent, the FOMC has promised tightening. We’re in uncharted territory here, but it’s most likely that won’t have a positive effect on GDP growth or employment. The CBO report expects 10-year Treasury rates to gradually increase between now and 2016 (averaging 4.3 percent that year); however, it is not clear to what extent FOMC policy is taken into account, especially their non-interest rate policy levers. (the CBO mentions this only in passing on page 40). I doubt any macro model, the CBO’s included, is able to deal with these “special circumstances”.

    Mr. Hennessey should probably have added this to his list of “That (CBO) projection excludes:…”

  7. The CBO can only report on figures that’s it’s been given by the government. Obamacare will set back the growth of the economy which in this report is not taken into account. Also, this rosy picture (not!) will be derailed by any number of things such as terrorist attacks or another economic bubble popping such as student loans or government pensions shortfalls that are coming to a head in many states across the country.

  8. There was a construction bubble from 1995-2005 (starting after lawyer Obama won a lawsuit against a bank for not giving mortgages to folks who probably wouldn’t pay them back. [3 of 187 are successfully paying theirs back.] from memory).
    This overinvestment in house construction resulting in Unsustainable Trend, Overemployment, a Bubble. There is no way to return to an unsustainable trend with any sustainable policy.
    Every attempt to return to the unsustainable trend will require some unsustainable policy.
    We need an intellectual group of opinion leaders, like yourself Keith, to be honest about never again achieving 5.5 unemployment (perhaps 1% overemployment from a sustainable, lower GDP producing 6.5%).

    I recall many Democrat journalists complaining about the Bush recovery as “not good enough”, when actually it was mostly “too good to last”.

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