The Economy, Fiscal Policy, and Monetary Policy1

Presentation to the Financial Women’s Association of San Francisco
San Francisco, California
By John C. Williams, President and CEO, Federal Reserve Bank of
San Francisco
For delivery on October 15, 2012

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Good afternoon. It’s a pleasure to speak to the Financial Women’s Association of San Francisco. My subject is how the U.S. economy is doing and where it’s heading. I’ll highlight where things are improving as well as some of the things that are holding us back. In doing so, I’ll take both a short-term and long-term look at the impact of fiscal policy on the economy. I’ll finish by going over measures we at the Federal Reserve recently announced aimed at boosting growth and getting us closer to our goals of maximum employment and price stability. As always, my remarks represent my own views and not those of others in the Federal Reserve System.

The events of the past five years have been tumultuous. We’ve lived through the worst financial crisis and recession in our country since the Great Depression. We still bear the scars of those events, but there’s no doubt our economy is on the mend.2 Private-sector payrolls have climbed for 31 consecutive months, adding nearly 4¾ million jobs.3 That’s more than half what we lost in the recession. After reaching a peak of 10 percent in October 2009, unemployment has declined by more than two percentage points to 7.8 percent. That’s real progress. But we’re still a long way from where we should be.

As for credit conditions, they’re much improved from a few years ago. For many borrowers, interest rates are at or near historic lows. And lenders seem more willing to extend credit. Consumer and business demand pent up during the recession is reviving. We can see that, for example, in car sales, which collapsed during the recession. Now, with auto financing rates at rock bottom and more people working, motor vehicle sales have climbed over 60 percent from their recession lows.

Another encouraging development is that housing is once more showing signs of life. Mortgage rates are at historically low levels and homes are extraordinarily affordable. Sales are rising, inventories have come down, and we’ve started working off the huge backlog of foreclosed properties. Nationally, home prices are starting to rise. Here in San Francisco, we can even say that the housing market is heating up.

The housing recovery includes a rebound in home construction, something particularly important for the health of the overall economy. Housing starts collapsed during the downturn, plummeting from a seasonally adjusted annual pace of over 2 million new units during the boom to around half a million in the depths of the recession. Such a dearth of homebuilding couldn’t continue if we were to have enough homes for a growing population. The latest data show housing starts rising to an annual rate of 750,000 units. That’s a big increase, but still well short of the longer-run trend of about 1.5 million units. Over the next few years, an ongoing recovery in housing construction should be one of the key drivers of economic growth.

I’ve highlighted a few sectors—autos and housing—that were hard hit during the recession, but are on their way back. Why then are we unable to shift into a higher gear of growth? Three reasons stand out: the European crisis, the budget squeeze at all levels of government in the United States, and a pervasive sense of uncertainty.

Europe’s problems have been a dark cloud hanging over global financial markets and our own economy for the past two years. What started as a financial problem in several European countries has morphed into a general economic downturn—and the shock waves are hitting us. U.S. companies are seeing lower demand for their products. The same is true for other countries that sell to Europe, such as China.

Recently, the European Central Bank announced a bold plan to stabilize the markets for government debt of countries under stress. Hopefully, this will buy enough time for European governments to put in place more comprehensive solutions for their banking and sovereign debt problems. But it is far from certain that European leaders will succeed in doing so. One challenge is that, in exchange for aid, authorities have demanded austerity measures, including tax increases and deep spending cuts. In the longer term, these measures are needed to put government budgets on sustainable paths. But, in the near term, austerity has held down economic growth further, prolonging economic downturns and making it tougher to trim budget deficits.

Europe is by no means the only thing pressing on the U.S. economy now. In our country, tax cuts and spending increases gave the economy a badly needed boost in the depths of the recession and early in the recovery. But these stimulus measures have been expiring. At the same time, states and localities have cut spending and raised taxes as they struggle to balance their budgets. As a result, fiscal policy in the United States has shifted from the accelerator to the brakes as far as growth is concerned.4

The numbers tell the story. Government consumption expenditures and investment have declined 5.3 percent over the past two years, adjusted for inflation. That’s equivalent to more than a 1 percent reduction in gross domestic product. Meanwhile, state, local, and federal government employment has fallen by 570,000 jobs, or 2½ percent, over the past four years.

Including these cuts, federal, state, and local government employment now make up about 16½ percent of all employment. Let me put that number in perspective. Figure 1 shows the trends in government employment as a share of total employment since 1955. The current government share is roughly the same as the average of the past 20 years, and well below the peak reached in the 1970s. Interestingly, federal employees constitute only about 2 percent of total employment today. That figure is less than half of what it was in the early 1960s.5

Of course, the elephant in the room in terms of fiscal policy are the huge federal deficits we’ve been amassing. Figure 2 shows federal deficits as a share of gross domestic product starting in 1930 and including projections by the nonpartisan Congressional Budget Office for the next 10 years based on current law. In recent years, taxes as a share of GDP fell to their lowest level since the early 1950s, while spending rose to its highest level. The result has been the widest deficits of the post–World War II era—over 10 percent of GDP in 2009 and projected still at 7 percent in 2012—requiring the government to borrow over a trillion dollars in that fiscal year.

This huge deficit is in part a product of the recession and slow recovery. As businesses closed and jobs disappeared, tax revenue fell. Meanwhile, spending soared as more people qualified for programs such as unemployment insurance. In addition, Congress and the White House boosted spending and cut taxes to stimulate the economy. Finally, unrelated to the downturn, tax rates put in place early in the past decade cut into federal revenue.

The drag on the economy could turn dramatically worse at the beginning of 2013. You may have heard the expression “fiscal cliff.” It refers to large federal tax increases and spending cuts that will automatically take place under current legislation. These include ending the temporary payroll tax cut and extended unemployment benefits. Caps on some federal outlays and sharp cuts in others are also set to go into effect. In addition, the Bush-era tax cuts are scheduled to expire. In Figure 2, you can see the fiscal cliff in the dramatic reduction in the federal deficit that would take place over the next few years under current law.

Now, I don’t expect all these tax hikes and spending cuts to take place as scheduled. For example, it’s likely that the Bush tax cuts will be extended temporarily and that some spending cuts will be deferred. Still, there’s little doubt that some austerity measures will hit, and that is likely to slow our economy’s progress.

If my prediction is wrong though, and the entire range of fiscal cliff measures stays in place, the effects on the economy next year would be much more severe. The Congressional Budget Office estimates that the complete fiscal cliff package would knock 2¼ percentage points off growth in 2013 and push unemployment up a percentage point compared with the less draconian scenario I expect. If that happens, the economy could find itself on the brink of recession.

Of course, fiscal policy is not the Fed’s responsibility. Under our system of government, Congress and the White House set the budget. Still, the Fed has a compelling interest because fiscal policy has such an important impact on the economy. Europe shows dramatically how government budget problems can wreak havoc with the economy.

I’ve been talking about fiscal issues in the context of our economy today and in the period just ahead. I’d like to take a moment to discuss the longer-term budget picture. Figure 3 shows publicly held federal debt as a fraction of the economy. Publicly held debt has jumped from 36 percent of GDP in 2007 to a projected 73 percent this year. This can’t go on. One lesson from Europe is that there are limits to how big government debt can grow. If our debt gets too big, a crisis of confidence could erupt.

What happens depends on the choices we make. Figure 3 also shows two Congressional Budget Office projections for the federal debt.6 The baseline scenario assumes that all the fiscal cliff measures take place.7 What’s striking is that federal debt steadily declines as a share of GDP over coming decades. Compare that with the CBO’s alternative scenario, in which the Bush tax cuts are extended indefinitely and some spending cuts are suspended.8 Federal debt literally shoots off the chart, reaching 200 percent of GDP in a few decades.

This chart paints a scary picture. But it’s important to keep in mind that many combinations of spending and taxes could put us on a sustainable path. The fiscal cliff scenario is only one—and not the most desirable one, because of the damage it would do to the recovery. But as the nation moves toward a sustainable budget, we need to make wise choices about how to spen