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What this recovery has taught us




This chart compares the long-term trend growth of real GDP to actual GDP, with today's Q1/11 GDP release included. What jumps out from the chart is the fact that the economy's level of output has been about 10% below its long-term "potential" output for more than two years. This is the biggest growth shortfall since the Depression, and it has persisted for more than two years despite unprecedented levels of fiscal and monetary stimulus.

Die-hard Keynesians are still unwilling to accept that stimulus has failed, and some, like Paul Krugman, still argue that the problem was that the stimulus wasn't big enough. But as I predicted in a post in January 2009, the fiscal stimulus package championed by Obama and the Democrats would prove to be a significant drag on growth, and I think the evidence now supports my prediction. You can't create growth out of thin air, or by transferring money from one person to another by government fiat. When government commandeers a big chunk of the economy's resources, as it did beginning two years ago, those resources end up being spent in a much less efficient fashion than if they had been left in the private sector. The result is slower growth. We're in a recovery, but it's a very slow recovery because government is smothering the economy.

Morever, with trillion-dollar deficits staring us in the face for as far as the eye can see, market participants, workers, and business owners can't help but fear an eventual and substantial rise in future tax burdens. Just the possibility that future tax burdens could rise meaningfully is enough to reduce the discounted, after-tax, present value of future cash flows, and to discourage, on the margin, new investments.

Monetary policy is also culpable. By adopting an unprecedented quantitative easing program, and promising repeatedly to keep short-term rates very low for an extended period, the Fed has introduced a significant amount of monetary uncertainty into the financial markets and the economy. Inflation expectations are rising, and the dollar has fallen to all-time lows, as capital decides that the U.S. economy is not a very attractive place to be. Treasury yields are still very low, despite our massive budget deficit, because an excess of spending is depressing the economy and depressing the expected returns on alternative investments.

So the lesson from this tepid recovery is that the more government tries to "stimulate" the economy, the worse things will be. If Washington and the American people can take this lesson to heart, then the pain and suffering of this slow-growth recovery will not have been in vain. This could end up being the best thing to have happened for the economic outlook since the early 1980s.

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