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Government Policies and the Delayed Economic Recovery
By Lee E. Ohanian, John B. Taylor, Ian J. Wright
Hoover Institution PressCopyright © 2012 Board of Trustees of the Leland Stanford Junior University
All rights reserved.
Economic Strength and American Leadership
George P. Shultz
My job, as I see it, is to put into perspective and underline the importance of restoring robust economic growth to America.
Let's start by recollecting the last century. We had wars, including two very large ones with millions of people killed and injured. We had the murderous regimes of Stalin and Hitler and, in a different way, that of Mao. We had social upheaval. We had the Great Depression. We had the ultimate degradation of humanity in the Holocaust. It was an awful century.
At the same time, it's stunning to realize that, since the end of World War II, we have seen probably the greatest burst of human progress ever. We live longer and we're healthier than ever before. To a great extent, that is attributable to the astonishing research that has been done on how the human body works and the identification of pharmaceuticals, procedures, and devices that have changed the whole outlook on health. To a large degree, those discoveries emanated from work done in the United States.
In the years since the end of World War II, Soviet expansionist tendencies were contained successfully, the Cold War was brought to a satisfactory end with little bloodshed, and an economic and security commons was created on a worldwide basis. Everybody, including the United States, has gained from that commons. Germany and Japan could not have come back so strongly, Europe would not have recovered as successfully, and China and India would not be undergoing their current expansions were it not for the global commons that has been created, largely with leadership from the United States.
Where are we now? Once again, the world is awash in change of a deep, penetrating, seminal nature, and the United States is not leading the way as it once did. Let me briefly identify the nature of the changes that are taking place, why it is essential for our own internal reasons to restore robust economic growth, and why it is essential for the world that the United States stand up and once again show, as Ronald Reagan did, that it is a shining city on a hill.
Consider the changes. The whole face of the world is undergoing drastic change. With the exception of the United States, all developed countries are seeing rates of fertility fall, longevity increase, and labor forces shrink in proportion to their total populations. These changes alter the outlooks and capabilities of countries such as Germany, Italy, Spain, and Portugal. France is holding its own demographically, only because a significant proportion of its population is Muslim, but as this segment of the population is largely unassimilated, it is more of a problem than an asset. Russia has a demographic catastrophe on its hands. Fertility is low and longevity for Russian men is about sixty, which is unbelievable in this day and age, but they're drinking themselves to death. Russian women live twelve years longer than their male counterparts. In some respects, China has the most interesting demography because its fertility rate dropped dramatically beginning about thirty years ago. The result is that for the last quarter-century, China's labor pool has been increasing at a good rate while the number of people the labor pool has to support has been decreasing, so they have had a demographic dividend. That's about to change, almost as if a light switch were being flipped. The labor pool will level off and then start to decrease. I use the term "labor pool" rather than "labor force" because there's so much underemployment in China. Nevertheless, this will be a big change. Furthermore, the number of people the labor force will have to support will be rising rapidly just as the labor pool is falling, so the demographic dividend will disappear and a demographic drag will suddenly take hold.
Looking at Africa, the Middle East, and the Maghreb, a different picture emerges. You see falling but still high fertility, no significant change in longevity, and relatively young populations with all too many young people unemployed. The world is moving toward a drastically different demographic scenario from that of forty years ago.
The United States has a healthy demography but we are jeopardizing it because we are not giving enough of our young people adequate educational opportunities. This is particularly noticeable in California, where there are poor schools in the low-income-per-capita Latino areas with growing populations. This problem needs to be addressed urgently, in my opinion.
In addition, we need to appreciate the depth and the impact of the information and communication revolution that has taken place. Leaders used to have a kind of monopoly on information and the ability to organize and communicate, but that is no longer the case. Almost anybody anywhere can find out practically anything, and they can easily communicate and organize themselves. This is drastically changing the problem of governance. The change is tough on long-standing autocratic regimes, but it's a challenge for open societies as well.
When you combine the information and communication revolution with the demographic situation, particularly in the Maghreb and the Middle East, you have a volatile mix.
It is important to remember that the Arab Spring was set off by the action of a small entrepreneur in Tunisia who wanted to start a small business selling things. His last words were: "All I want to do is work." Remember that phrase, because work attaches people to reality. Without work, there's little sense of reality. The Tunisian shopkeeper wanted to get attached to reality but his government wouldn't allow it.
The third major movement in progress is the Arab Awakening. I don't use the term "spring" because it implies that there is some sort of inevitable progression. At this point, I don't think anybody knows quite where this is going. We must have the ability to work with this seminal development, and it is a powerful reason why we need to restore robust economic growth.
I call what is happening the Arab Awakening, but an awakening is going on all over the world. It is clear enough that China is very concerned about these trends. In an earlier career, I was a labor economist and I served as an arbitrator and mediator. In labor circles, it's said that there is only one thing worse than a wildcat strike, and that's a successful wildcat strike, because success teaches people how to get something to happen. The spreading Arab Awakening is, in a sense, a series of successful wildcat strikes by groups of people who don't know where they're going but know that they have managed to bring down regimes. A seminal change is taking place in an area of the world that is very important in the arenas of energy and religion. If this change spreads to India and Pakistan, which have nuclear weapons, it will potentially create an explosive situation.
We have seen the emergence of random violence, or terrorism, much of it inspired by radical Islam. This phenomenon, particularly noticeable in the last ten years, but which has been going on for quite a long while, has imposed a cost on us that is heavier than many people appreciate. It is more than just taking off your shoes at the airport. Our embassies used to hang out welcome signs; now they look like fortresses. We've had two very costly wars, and there is a general sense of unease, so a heavy cost is being paid.
The state system is no longer what it used to be. We tend to think of the world as being organized into states that interact in certain ways, but the state system, while still key, is eroding. There are many areas, particularly in Africa, where there is little real government. There are other areas that lack a sovereign or orderly government capable of making a difficult deal with another country and having that deal stick. This problem exists even in the ancient nation-states of Europe because, to a degree, they don't know whether they're in a country, a European community, or the Eurozone, so they pass the buck and, in the process, manage to avoid confronting reality. So in many ways the state system is breaking down. The global financial crisis seems to be a toxic combination of governmental and financial incompetence or inability to confront the realities that are facing people and design a strategy to deal with them. I use the term "strategy" because we seem to be capable of implementing only short-term fixes.
When the world was awash in change in the twentieth century, the United States was a global leader that produced ideas, gave crucial support to other countries, and rallied allies. It did not impose its will on others but, to a great extent, it was a shining city on a hill — an example that inspired people around the world. The United States also exerted influence by saying: here is the right course and this is what we're willing to do.
I'll take an example that's totally out of the economic sphere just to make the point. In the 1980s the world was affected by a problem with the ozone layer. We could see that if the ozone layer depleted there would be dire consequences. There were arguments among scientists, but most of them agreed that the ozone layer was being depleted. Even among the doubters, there was no disagreement that total depletion of the ozone layer would be catastrophic, so Ronald Reagan managed to take out an insurance policy called the Montreal Protocol. The United States led in providing the scientific basis for the Protocol. The United States also led in diplomatic efforts to encourage other countries to support the measure. The United States led as an example to the world and the problem was resolved. As it turned out, the scientists who had been alarmed about ozone depletion were right, so action was taken in the nick of time.
U.S. leadership is not as strong now as it was in the 1980s. There are many reasons for this, but certainly a central factor is our economy, which is in the doldrums. People seem to be wondering what can be done. Recently, I read that our secretary of the treasury went to a European meeting and the Austrian finance minister spoke condescendingly to him, basically saying: "What do you know? Don't bother us with your silly advice." Can you imagine the finance minister of Austria saying that to the secretary of the treasury of the United States?
We need to get our house in order and, at least as I see it, there are obvious and simple ways to achieve this goal. At today's meeting, I expect that we will discuss the simple, obvious actions that we should take. We can then transmit them to the powers that be in hopes of getting our country moving forward once again.CHAPTER 2
Uncertainty Unbundled: The Metrics of Activism
My special task is essentially to focus on the short- and intermediate-term issues that relate to the United States. However, these issues can just as readily be expanded to the rest of the developed world, and I will spend some time discussing Europe as well. I agree with George Shultz's opening remarks about American global leadership. It saddens me to say that. It's a terribly gloomy commentary on where we are, coming from someone who has obviously participated in an extraordinarily large amount of public policy for so long.
Beginning with the United States, let me start with the first important question: how is it that we've had such an extraordinarily sluggish, historically unprecedented degree of near stagnation, which in many respects is characteristic of what we saw in the 1930s? (Fortunately not as deep, but the characteristics are the same.) Let me take the current economy and try to define what's wrong with it. Figure 1 shows both nominal and real values of investment in private structures as a share of gross domestic product (GDP).
I present the share both in nominal terms and in real terms just to indicate how significant the differences are. The shaded lines represent National Bureau of Economic Research (NBER) recessions. Note that in every recovery from 1949 forward, a disproportionate amount of the recovery comes from private structures, both residential and non-residential. However, something unprecedented has happened at the tail end of Figure 1: the amount invested in private structures as a percent of GDP steeply declined.
Figure 2 shows my calculation of an average durability of real private domestic GDP, plotted alongside real private fixed investment in structures (as in Figure 1) as a percentage of real GDP.
To obtain the average durability measure, I constructed a vector of all the elements of GDP in its greatest detail and associated each component with a longevity. For example, a haircut is one month. Software is about three-and-a-half years. Residential buildings are seventy-five years. A very large segment of the average age vector is calculated by the Bureau of Economic Analysis as part of its capital stock data system. I used their calculations as much as possible and added my own where necessary. Most services, I assumed, have zero life expectancy. In the end, of course, the longer term components are what drive this calculation. The average durability of private domestic GDP is highly correlated with, and can be proxied by, the investment in private structures.
What would have happened had investment in structures not declined, but rather behaved as it had in the other post-war recoveries? Figure 3 shows that GDP would have replicated the GDP changes of previous recoveries (as shown by the simulated path relative to the actual path of GDP). To compute the simulated path, I assumed that the pre-recession intermediate downward trend in structural investment continued as population growth slowed — you would expect the production of buildings (which are a major part of structures) to be somewhat depressed. Using this hypothetical measure for the structures component of GDP, given that the rest of the GDP followed its actual path to date, produces a reasonable counterfactual GDP forecast.
As shown in Figure 3, there is a fairly significant gap between the actual and the simulated GDP. The cumulative difference between the two represents just over three percentage points of annual GDP, which, by my estimation, is essentially the equivalent of three fewer percentage points in the current unemployment rate. As a consequence, were structures behaving normally, the unemployment rate would be below six percent rather than at about nine percent. And the economy would not be categorized as very sluggish.
In short, we're experiencing a significant reduction of long-lived assets. This results from a very heavy discounting as the time frame moves out from current short-term to longer-term outputs.
Figure 4 shows fixed investment divided by cash flow, for nonfarm nonfinancial corporate business, a measure of the share of cash flow that corporate management chose to invest. I find this statistic to be one of the most useful means to determine the degree of uncertainty of corporate management, which, of course, has led to heavy discounting and the recent drop-off in investment in structures. Figure 4 shows that management has chosen to invest a very low (almost record low) share of cash flows recently. The ratio is hovering at its lowest levels in the post — World War II period. You have to go back to 1940 to see anything close to it during peacetime.
The numbers suggest that the very long-term outlook is so uncertain that few are investing.
Before I joined government, well back into the last century, I worked extensively for corporate management, specifically in the capital investment area. And while that work differs in some ways from today's practices, and differs among companies, two criteria were generally employed to determine what part of the liquid cash flow is appropriate for the company to invest in illiquid long-term assets. We first estimated the expected rate of return (discounted by the corporation's hurdle rate) of a particular facility that the product managers or others within the corporation determined would be useful. If the rate of return of that proposed facility exceeded the cost of capital, then we went to step two. Step two, which turned out to be most important back then as now: the computation of the variance of the average forecast. In my experience, what killed most of the prospective capital projects was too large a variance. This is precisely what we are experiencing today.
Short-term capital investment — in equipment and software, for example — as a percent of GDP, is following the path of what we've seen in earlier periods. It's the lack of long-term investment in structures that is creating the problem.
Excerpted from Government Policies and the Delayed Economic Recovery by Lee E. Ohanian, John B. Taylor, Ian J. Wright. Copyright © 2012 Board of Trustees of the Leland Stanford Junior University. Excerpted by permission of Hoover Institution Press.
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Table of Contents
ContentsIntroduction Lee E. Ohanian and John B. Taylor,
1 Economic Strength and American Leadership George P. Shultz,
2 Uncertainty Unbundled: The Metrics of Activism Alan Greenspan,
3 Has Economic Policy Uncertainty Hampered the Recovery? Scott R. Baker, Nicholas Bloom, and Steven J. Davis,
4 How the Financial Crisis Caused Persistent Unemployment Robert E. Hall,
5 What the Government Purchases Multiplier Actually Multiplied in the 2009 Stimulus Package John F. Cogan and John B. Taylor,
6 The Great Recession and Delayed Economic Recovery: A Labor Productivity Puzzle? Ellen R. McGrattan and Edward C. Prescott,
7 Why the U.S. Economy Has Failed to Recover and What Policies Will Promote Growth Kyle F. Herkenhoff and Lee E. Ohanian,
8 Restoring Sound Economic Policy: Three Views Alan Greenspan, George P. Shultz, and John H. Cochrane,
9 Summary of the Commentary Ian J. Wright,
About the Authors,
About the Hoover Institution's Working Group on Economic Policy,