Economic recovery is inevitable, but better policies influence it

Published: Monday, May 14 2012 5:41 p.m. MDT

The U.S. economy has been through several rough years, beginning with a severe recession in 2008 and an anemic recovery since. The economy has actually been growing since June 2009, but it hasn't felt like it to many Americans. The employment rate has been slow to recover compared to most postwar recessions. But despite the weakness of the recovery, things are not as bleak as they seem. The longer the recovery remains weak, the greater the potential for future economic growth.

The U.S. economy is characterized by two important features. First, the number of goods and services produced per person (GDP per capita) grows over time with a fairly reliable trend of around 2 percent per year. Second, GDP per capital does not grow smoothly over time, but proceeds with periods of rapid growth and other periods where the size of the economy actually shrinks. We call these downturns recessions, and the upswings are called booms or recoveries.

The processes that drive these two features (growth and fluctuations) are distinct, but related. For example, oil price shocks can send the economy into a recession, but are unlikely to have long-run effects on the overall growth rate of the economy. For the most part, economic growth is driven by a complex set of processes. Some of these cause implemented technology to rise over time. Others influence the desired savings and consumption of households. Still others are random shocks to supplies of key goods and services, and they could result from political turmoil or natural disasters. Economic fluctuations are driven largely by these unanticipated, uncontrollable shocks to the economy. One important source of shocks that is controllable, however, is government policy.

The most obvious source of government policy shocks is changes in taxation. An increase in productivity will increase the number and value of goods any given worker can produce. This causes an increased demand for workers (more jobs) and an increase in wages (higher incomes) along with an increase in goods and services produced (higher GDP). A decrease in tax rates on firms will have the same effect. From the firm's perspective, it doesn't matter if the increase in goods comes from being able to produce more or from the government taking less.

Another example of policy shocks is the imposition and removal of regulations on how goods are produced. Safety and environmental regulations add to the costs of producing goods and services and, in effect, force firms to adopt technologies that are less efficient. If there are externalities (i.e., costs born by people other than the producers or consumers of the goods) and the regulation is appropriately chosen, then overall people will be better off. However, if the externalities are small or the regulation is inappropriately restrictive, people could end up worse off. In either case, however, when regulations change often and unexpectedly, they can lead to fluctuations in economic activity.

Taxation and regulation also affect economic growth because they affect the returns from investing in technology. Lower after-tax returns on innovation lead to less innovation and slower growth. Heavy regulation of the way R&D is conducted will induce less expenditure on R&D.

The slow recovery we have been experiencing is likely due in no small part to the effects of expected taxation, regulation and the uncertainty associated with how they are likely to change in the near future. For example, how burdensome will the costs of Obamacare be on the typical firm? The answer to this depends a great deal on what the Supreme Court says on the subject this summer. And right now the outcome of the court's decision is very uncertain.

Despite these dampening effects, growth in the application of technology has not slowed appreciably. This means that labor productivity in terms of output-per-hour-worked has been rising. Eventually this will translate into a greater demand for labor and an increase in production of goods and services. Detrimental policies in the short run can delay this inevitable recovery, but cannot stop it. In fact, the longer the recovery stalls, the stronger output is likely to surge when it occurs.

All this assumes, of course, that the growth in applying technology does not slow down appreciably. As noted above, high tax and regulatory burdens can dampen innovation if they remain in place permanently. If this happens, the economy will have fewer new technologies to implement. In that case, recovery is still inevitable in the sense of wages, jobs and GDP per capita returning to and surpassing their previous highs, but long-run growth rates will be lower, resulting in incomes rising more slowly than has been the case in the past.

Hence, recovery is inevitable if we wait long enough, but better policies are likely to bring about a more rapid recovery and return the economy to a higher long-run growth path.

Kerk Phillips is an associate professor of economics at BYU.

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