Why Is the U.S. Economy Still Depressed?: DeLong FAQ

by Brad DeLong

Arithmetically, the U.S. economy is depressed because residential construction and government purchases are well below previously-expected trend levels...

Back in 2007 those whose business it was to forecast the American economy were confidently projecting that, come 2015, nominal GDP--the total amount of spending in dollars on currently-produced and marketed goods and services in the United States, plus imputed rent on owner-occupied houses--would be $21.5 trillion. It will be about $18.3 trillion. Back in 2007 they were projecting that real GDP at 2009 prices would, in 2015, be $18 trillion. It will be $16.5 trillion. Back in 2007 they were forecasting that 87% of 25-54 year-old males would have jobs, not 84%. Back in 2007 they were forecasting that 72% of 25-54 year-old females would have jobs, not 70%.

Why? At the arithmetic level, it is because residential construction and government purchases have fallen far below their expected trends by a lot, consumption spending has fallen below its previousy-expected trend by a little, business investment is more-or-less at its previously-expected trend, and only exports have boomed relative to 2007 expectations.

Just because one component of spending falls off in relative terms does not mean that the economy must fall into depression. Take a look at the graph above over 2005-2008. The housing bubble bursts, housing prices collapse, and the pace of residential construction collapses--but exports and businesses pick up the slack. Why? Because money flows that would have gone to funding residential construction were switched to purchasing exports from America and were loaned to businesses that stepped up their pace of expanding their capital stocks instead. When an excess supply of finance emerges because one component of spending declines, the financial market and the Federal Reserve are supposed to guide interest rates down, thus signaling to other potential components of spending that finance is available and can be put to work.

But in 2008 this so-called "credit channel" collapsed as Wall Street in particular and American finance in general broke down. 2008-2009 saw all of business investment, residential construction, and exports--plus consumption spending--collapse, with only Obama's feeble Recovery Act working in the other direction. And it was only large enough to offset one-eighth of the collapse in the other salient components of aggregate demand. Hence the deeply depressed economy of late 2009.

And since? Short-term safe interest rates have been at zero. Finance is still potentially available, but the Federal Reserve lacks the tools to guide the interest rates it controls below zero. And the private financial market is still too spooked to push risky interest rates down and asset prices up further relative to safe rates. So there is no economic signal available to make financing business equipment investment and consumption spending even cheaper and so inducing businesses and consumers to do enough of it to push the economy to full employment. The same is true of single-family residential construction (multi-family has recovered to normal).

And governments are not responding to market signals: financial markets are telling them that they have a once-in-a-lifetime opportunity to advantageously pull spending forward from the future into the present and push taxes back from the present into the future. But, because of the ideology of austerity, they are not taking advantage of this opportunity.