Today we learned that the U.S. economic downturn has been much more severe than previously understood and the economy is growing much too slowly to keep unemployment from rising. The economic downturn was 24% deeper than previously assumed, and actual economic output currently stands a staggering $882 billion (5.6%) below potential. The anemic recovery has been losing steam for months, explaining the sharp deceleration in employment growth in May and June. As the U.S. Congress frantically debates an eleventh hour resolution to an artificial crisis of epic proportions, the real crisis in the labor market goes tragically ignored -- and it is about to be amplified by bad policy choices. Unfortunately, the only conceivable debt ceiling compromises will further slow economic growth and exacerbate the unyielding crisis in the labor market. Today's depressing GDP numbers should serve as a clarion call to refocus Washington's attention to jobs and the economy.
A month ago, it seemed possible, albeit unlikely, that a little more incremental economic support might be included to grease the wheels of a deficit reduction package, which has been forced onto the traditionally pro forma vote to increase the debt ceiling. Last December's tax cut and unemployment extension compromise had even set a precedent for such an outcome: the deal reduced payroll tax rates by two percentage points on the employee side and continued emergency unemployment insurance through 2011 in exchange for extending the Bush-era tax cuts for the top 2% of earners. Despite clear warning signs that the recovery is faltering and job gains are decelerating, no stimulus has been enacted since.
In a primetime speech on the debt ceiling impasse on July 25, President Obama explicitly endorsed extending the payroll tax cut for working families -- the only extra economic support seriously discussed this Congress. The president and Congress should seek more support for the economy, but the payroll tax cut is an inefficient and inequitable means to this end. A better way to create jobs would be to replace the payroll tax cut with a targeted tax rebate, similar to the one signed into law by President Bush in 2008. (Back then, the unemployment rate rising to 5.0% was enough to prompt $115 billion in tax stimulus.) Targeted tax rebates would do more to alleviate poverty than a payroll tax cut extension and end Social Security's politically risky dependence on general revenue, but it would also generate roughly 12% more economic activity and jobs per dollar.
At first blush this may seem trivial, but look at it this way: If Congress had passed the more efficient, targeted tax rebate instead of the payroll tax cut, we would be seeing roughly an additional 10,000 job gains a month -- a 55% increase relative to the dismal 18,000 jobs created in June. A targeted tax rebate is far too small to abate the unemployment crisis, but this would be a step in the right direction -- the first since December despite a steady stream of alarming economic data. Squeezing any additional economic support out of the federal budget -- the most direct policy lever for increasing employment -- has become a grueling exercise for those of us still fixated on the real economic challenge. While deficit-financed direct infrastructure investment and more state fiscal relief would certainly be far superior job creation policies to be complemented with additional tax stimulus, the national political conversation has strayed depressingly far from rational policymaking. Why?
Washington is instead focused on reducing government spending. And let's be clear, this partisan stalemate is not about the deficit -- if it were, House Republican leaders would not have walked away from negotiations -- not once, but three times -- over drawing slightly more tax revenue out of our antiquated system of deductions and preferences. This is about an ideological war on government's expenditure and role in society. To that end, conservatives have argued that spending cuts will actually help the economic recovery -- an assertion that private-sector forecasters find laughable. Between high unemployment and historically low interest rates (the result of anemic private-sector demand and Federal Reserve policy actions), there is zero scope for expansionary fiscal contraction. Indeed, the deep, near-term discretionary spending cuts in both the House and Senate debt ceiling plans will further undermine the faltering economic recovery.
Even if this were about the deficit, there is only one mechanism by which long-term deficit reduction will help the economic recovery: lower interest rates, thereby crowding-in private-sector investment. (As Paul Krugman repeatedly points out, there is no confidence fairy to magically lead our way onward to recovery.) There is no evidence of government crowding out private-sector borrowing, which makes sense because our economic woes stem from inadequate demand and abundance of unemployed labor and unused industrial capacity.
If this charade was meant to lower interest rates and convince the bond market that Washington's leaders are truly serious about addressing long-term fiscal imbalances, things could hardly have gone worse. Writing in yesterday's Washington Post, Mohamed El-Erian, CEO of PIMCO, warned that any benefits from long-term deficit reduction would be completely offset by how it was achieved, even if the United States avoids both a default and a credit rating downgrade. (Of course, the House Republican debt ceiling plan reportedly still risks a credit downgrade because it forces a repeat of this brinksmanship half a year from now.)
So what will Congress have accomplished through this debacle? Higher interest rates, a credit rating on review, lower employment, and public furor. Best case scenario: we will avoid an unnecessary credit downgrade, default, and financial crisis. Our national politics have become mind-bogglingly asinine; almost as insulting has been the deliberate effort to unlearn every Keynesian lesson from the Great Depression. It's still the economy, Congress -- not the concocted, phony debt crisis. Boosting the economy is not at odds with responsible long-term deficit reduction; indeed deficit reduction of any sort will be immensely difficult if economic output remains nearly a trillion dollars below potential and the recovery continues decelerating. We have the policy tools to restore full employment; we have the ability to service our debts and meet our obligations; we just lack the political will to prioritize policies for economic recovery and instead hope the economy somehow magically recovers all by itself.