In the Longer Run, the Short Run Matters

The worst of the deadlock between the House and the White House has passed, and there are even signs that a compromise may now be reached addressing long-run budget issues. We are in a better place politically than we were late last year, but still in no position to get complacent about near term economic prospects. Chances of renewed recession are low, but so are prospects for vigorous expansion.

For the past two years, the need for fiscal and monetary stimulus has been debated both in Washington and Wall Street. One thing that has been missing from these debates is the potential for longer run damage if the sluggish economy persists. When a recession is brief and the economy returns promptly to high rates of employment, the long-run costs are minimal. But when recovery is weak and joblessness persists for many workers, the long-run costs become meaningful. And they include worsening the long-run fiscal problems that concern everyone.

The economy’s economic potential depends on the size and skill of the work force, the size and quality of the capital stock it works with, and the technical innovations that accompany the new capital. Although future investment can provide the needed capital and innovation, losses on the labor side are likely to be more lasting. In a prolonged slump, unemployment spells become long, discouraged workers stop looking for jobs, and job skills erode or become obsolete. Older workers retire earlier than they had intended. Young workers find few career path job openings and miss the on the job training that is part of the transition from school to the workplace.

Problems remain

All these problems are present today. The job market has improved greatly since the depths of the recession, but there are still 5 million more unemployed than before the recession started. Over this period, the number of people unemployed more than half a year has risen by 3.5 million. Furthermore, the labor force participation rate is 2.3 percentage points lower than it was in 2007. If the overall participation rate had not changed, the labor force would be nearly 6 million larger today. However, this difference reflects both natural changes in participation for various demographic groups and a large number of discouraged workers who have stopped looking for work because of economic conditions. A return to a strong job market would bring back some of these discouraged workers. But the longer the slack labor market continues, the more permanent these effects are likely to be.

The Congressional Budget Office continually updates its projections of potential GDP, and those projections are heavily influenced by its estimates of these labor force developments. Comparing its most recent estimates of potential for 2012 with the projections for 2012 that it made in 2007, we can infer that the recession and slow recovery have reduced potential GDP by $800 billion. Because tax revenues are correspondingly lower and transfer payments somewhat higher, the structural budget deficit, which measures what the deficit would be if cyclical factors were removed, is higher by about $160 billion this year and by perhaps $1.75 trillion over the next ten years. A rapid recovery would improve these prospects and sustained high unemployment could worsen them.

Toward a solution?

All this raises the question of what to do about it.

The Federal Reserve can be expected to continue its monetary easing for as long as necessary. Its example is winning over some foreign central bankers even if not its critics at home. The recent decline in commodity prices, and the persistent low yield on long bonds, provide continuing market evidence that Bernanke and his colleagues are on the right track.

But they need help from the fiscal side. After the initial stimulus package that was passed in 2009, resistance to budget deficits has led to some fiscal tightening in each subsequent year. Last winter’s budget deal that avoided the extreme tightening of the fiscal cliff itself imposed a considerably tighter budget this year.

That’s not good.

Near term fiscal policy should be guided by the doctors’ oath: first, do no harm. While pursuing measures to reign in deficits in the fairly distant future, immediate budgets should be as expansive as politics allows.