Where Do We Go From Here?

At Our Daily Bread Employment Center in Baltimore, people line up for the daily Hot Meal Program, held seven days a week.

To prevent the recession from spiraling into a full-blown depression, the federal government used deficit spending to stimulate the economy and push it towards recovery. Deficit spending—meaning that the government is spending more money than it collects in tax revenue—falls well within the mainstream of economic theory on how to respond to recessions. In this case, it was needed to make up for a dramatic shortfall in demand as the economy contracted by 6.4 percent in the fourth quarter of 2008 and by 5.4 percent in the first quarter of 2009.¹ Contractions of this magnitude haven’t been seen since the Great Depression.

In March 2009, the president and Congress passed the American Recovery and Reinvestment Act, pouring $787 billion into the economy over the following couple of years. This was an unprecedented amount of federal stimulus during a recession, and it came at a time when the government was already running a budget deficit of $455 billion.² The nation’s top economists widely supported the stimulus package. Where they disagreed was on how much stimulus was needed and how the monies should be spent. Tax cuts? Spending on infrastructure? Expansions in unemployment insurance and nutrition programs? Dollar for dollar, spending on infrastructure and safety net programs stimulates a higher return on investment than tax cuts,³ which led the president and Congress to choose to spend more on the former.

However, deficit spending is not a sustainable economic strategy. Governments, like households, have to eventually live within their means. The federal budget deficit reached $1.4 trillion in 2009.⁴ When adjusted for inflation, this is the largest percentage of Gross Domestic Product (GDP) since World War II. In a recession, the immediate concern of policymakers is to stabilize the economy and reduce the suffering caused by job losses. With the unemployment rate projected to remain above 10 percent through 2010,⁵ government spending to mitigate the suffering of those out of work will be essential. Balancing the federal budget is not a high priority while unemployment is climbing. But once the economy has stabilized and unemployment falls, the president and Congress will have to focus on reducing the deficit. If they do not, they run the risk of another major problem: rising interest rates, which generally drive down private investment and often lead to an upsurge in inflation.⁶

Recessions, and recoveries from recessions, do not follow identical patterns. Past recoveries received a strong boost from the housing sector,⁷ but that is unlikely to happen this time. High unemployment means that home foreclosures will continue to rise. The Center for Responsible Lending estimates 2.4 million new foreclosures in 2009 alone, and more than 8 million foreclosures between 2009 and 2012.⁸

The strength and vitality of any recovery depends on consumption, because consumption accounts for 70 percent of all U.S. economic activity. But this time around, recovery will occur in the wake of $8 trillion in lost housing wealth and trillions more in lost stock wealth.⁹ One in five mortgages is “underwater,” meaning that the homes are now worth less than the amount of the mortgage.¹⁰

Debt as a Percentage of Disposable Income, 1947-2007

The illusion of wealth during the bubble years fueled a consumption binge; U.S. households racked up levels of debt they can no longer sustain. For many homeowners, housing wealth cushioned the effects of stagnant wages and allowed people to continue spending above their means. In hindsight, taking on such huge amounts of debt seems irrational. But at the time, most people simply did not realize that the value of their homes was inflated. Some economists warned of the bubble and its consequences. But it is not the responsibility of economists, who mainly work in academic institutions, to safeguard the economy. Only government officials have the tools to deflate an asset bubble that threatened to wreck the economy.

So, where do we go from here? Some kind of structural change appears unavoidable. The Congressional Budget Office predicts a significant reduction in consumption through 2014.¹¹ “Consumers won’t start spending until they have money in their pockets and feel reasonably secure, but they don’t have the money and it’s hard to see where it will come from,” says Robert Reich, who was Secretary of Labor during the first Clinton administration and one of the economists who warned policymakers not to ignore the consequences of the housing bubble.{footnote}Robert Reich (July 13, 2009), When Will the Recovery Begin? Never.{footnote}

“Instead of asking when the recovery will start,” says Reich, “we should be asking when and how the new economy will begin.” The U.S. economy needs more than a short-term fix. It needs new ways of generating revenue that are sustainable and can create jobs to last long after the recovery.

Issues