The U.S. Economy Could Recover Faster If Government Policies Changed

Recent monthly employment reports have confirmed that this is the slowest U.S. recovery from a recession since the Great Depression. Four years after the recession began, unemployment is still above 8 percent, more than three percentage points higher than it was before the recession began. Critics of President Obama argue that the sluggish recovery is due to economic policies he pursued, such as bailouts, extended unemployment insurance, healthcare reform and reform of financial regulation, which was part of the Dodd-Frank Act. Regardless of policy decisions made since 2008, considerable evidence supports the assertion that the slow recovery can be blamed at least partly on the fact that the recession was caused by a financial crisis. Nevertheless, with better economic policies, the recovery would have been faster and more people would be employed today.

Recoveries are notoriously slow after major financial crises, as documented in the book “This Time is Different: Eight Centuries of Financial Folly,” by Reinhart and Rogoff. The financial crisis resulted from expansionary monetary policy and the resulting low interest rates, which led to excessive borrowing for investment in housing. When housing prices collapsed, millions employed in housing construction and related industries lost their jobs. Because of failures of major financial institutions due to excessive risk taking, lenders became much more cautious, making it difficult for entrepreneurs to invest in new enterprises that would create jobs to replace those that were lost.

In a free market economy, the recession itself causes price changes that create incentives for job creation. Unemployment leads to falling wages, and firms’ reluctance to borrow leads to falling interest rates. These changes provide an incentive for entrepreneurs to hire additional workers and increase investment in capital goods. The problem now is that the price and interest rate incentives that would motivate firms to invest and create new jobs have been offset by uncertainty about the future that discourages investment and job creation. Much of this uncertainty is due to federal government policy.

One source of uncertainty is rapidly increasing government debt and concern about how the debt will be financed. Both parties share blame for rapidly rising government spending and debt, since spending also grew faster than the economy under President Bush.

To slow the growth of government debt, the Obama administration and Democrats in Congress want to raise tax rates when the Bush tax cuts expire in January 2013. A tax increase would reduce consumer spending, but the biggest problem with a tax increase is that it reduces the incentive to work, invest and take risks, particularly among entrepreneurs who start and manage businesses.

Without a large tax increase, rising debt due to increased government spending means that government is taking a growing share of a limited pool of savings, meaning less will be available for private investment. Although low interest rates make investment projects affordable now, rising government debt may lead to higher interest rates in the future. This discourages investment in higher order capital goods, whose profitability may depend on consumers’ or producers’ willingness to borrow in the future.

Some economists, such as Paul Krugman, argue that the problem is not too much, but too little economic stimulus spending. When government borrows more to increase spending, however, there will be an offsetting reduction in private borrowing for investment. Private investment enables firms to produce more goods and services that people value, while government investment goes to projects that often provide little of what consumer’s value, as illustrated by government subsidies to failed solar energy company, Solyndra.

As economist Gary Becker notes in his blog, expansion of means-tested benefit programs also contributed to the slow recovery by making people less willing to work full-time. Extending unemployment insurance to 99 weeks reduces the incentive to search diligently for a job, enabling unemployed workers to be choosy. Changes that have made the food stamp program more generous, along with policies to reduce mortgage debt for low income people, also make it easier to wait for a better job offer or work part-time rather than full-time. Such policies are one reason why high unemployment coexists with more than three million job openings per month, many of which remain unfilled.

The financial crisis is to blame for the depth of the recent recession and partly to blame for the slow economic recovery. If market forces were allowed to work, however, the economy would recover more quickly. If they did not have extended unemployment compensation, some unemployed workers would find and accept new jobs. If uncertainty about government policy and its impacts weren’t such a big concern, firms would be willing to invest in expanding production in response to lower interest rates. A return to a system with fewer entitlements, less government spending, stable rules and a commitment to maintain low tax rates would increase confidence about the future so businesses and households would be more willing to invest and create new jobs.


Dr. Tracy C. Miller is an associate professor of economics at Grove City College and fellow for economic theory and policy with The Center for Vision & Values. He holds a Ph.D. from University of Chicago.

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