The State of the Economy

I testified yesterday before the House Budget Committee regarding the state of the U.S. economy.I emphasized the following points:

• In CBOs judgment, the economy will stop contracting and resume growing during the second half of this year, but the hardships caused by the recession will persist for some time. We now expect that the recovery will be more tepid than we had projected earlier. In particular, the growth in output later this year and next year is likely to be sufficiently weak that the unemployment rate will continue to rise into the second half of next year and peak above 10 percent. Economic growth over time will ultimately bring the unemployment rate back down to the neighborhood of 5 percent seen before this downturn began, but that process is likely to take several years.
• On the positive side, the fiscal stimulus provided by the federal government is now beginning to boost the economy, and financial markets show clear signs of improvement since the fall and winter. However, many factors will likely temper the strength of the recovery: the loss of household wealth, the fragility of financial institutions, persistently weak growth in the rest of the world, a surplus of housing units on the market, and low utilization of manufacturing capacity.
• Even if the economy returns to positive growth this year, the loss in output and income during this downturn will be huge. In CBOs March forecast, the difference between the economys actual and potential output will average 7 percent of GDP (which is equivalent to about a trillion dollars) this year and next, and that gap in output will not close until 2013. CBOs forecast in August is likely to show even larger shortfalls in output over the next few years. By this measure, the current recession and its aftermath will be the most severe economic downturn of the postwar period.

• The persistence of high unemployment in CBOs forecast does not stem from a failure of fiscal stimulus. We expect that the stimulus legislation will boost GDP a little more than dollar-for-dollar of reduced tax collections and increased outlays. However, as large as the stimulus package is, the contraction in underlying demand is far larger, so the stimulus will offset only part of the contraction.
• Most experts believe that larger budget deficits are appropriate during recessions, because higher spending and lower taxes can bring the levels of resource use and output closer to the economys potential. Therefore, the extremely large deficit this yearroughly $1.7 trillion, or nearly 12 percent of GDP, in CBOs March projectionserves a purpose. However, most experts also believe that persistent large deficits reduce capital accumulation and thereby slow the growth of output and incomes over time. Thus, the large deficits that CBO projects for the years after the economy has returned to full employment are more worrisome. Moreover, the sharp increase in debt this year and next raises the risk that investors might lose confidence in U.S. government debt as a safe haven. This risk heightens the importance of putting the budget on a sustainable path as the economy returns to full employment.