The following are excerpts from Federal Reserve Bank of New York President William Dudley”™s prepared remarks Oct. 15 at the National Association for Business Economics annual meeting in New York City, addressing reasons for the disappointing economic recovery and tools yet available to policymakers.
So why has the recovery disappointed?
One possibility is that the negative dynamics of a post-bubble environment are even more potent than had been appreciated. Feedback loops may be more powerful and frictions may be larger. In the U.S. case, this is particularly germane with respect to housing and mortgage finance. For example, we have found significant shortcomings in those institutional structures available to support the workout of the overhang of mortgage debt in an efficient and timely manner.
A second reason may be the series of additional negative shocks experienced since the initial phase of the financial crisis. The largest of these relate to the crisis in the eurozone, but one could also add the periodic commodity price shocks; the disruptive impact of the tragic Japanese earthquake and tsunami on global trade and production; and the effect of the uncertainties around the impending fiscal cliff on hiring and investing.
That said, the shocks since the acute phase of the crisis in the United States were not uniformly negative. Take, for example, the sharp increase in U.S. oil and natural gas production stemming, in part, from the innovations in drilling and extraction technologies. Not only does this rising production directly boost real GDP, but also the large drop in natural gas prices has significantly improved the industrial competitiveness of U.S.-based businesses.
A third reason for the weaker than expected recovery likely lies in the interplay between secular and cyclical factors. In particular, I believe that demographic factors have played a role. ”¦ In the United States, for example, the baby boom generation, which is a particularly large cohort, is now beginning to retire. As the population ages, this has two consequences: first, the spending decisions of the older age cohorts are less likely to be easily stimulated by monetary policy. That is because such age groups tend to spend less of their incomes on consumer durables and housing. Second, as the population ages and the number of retirees climbs, the costs associated with Social Security, government pensions and health-care retirement benefits increase. This creates budgetary pressure and leads to a choice of raising revenue to fund these costs, cutting other government programs, or cutting benefits. ”¦
A fourth reason ”¦ may be that we overestimated the capacity for fiscal policy to continue to provide support to growth until a vigorous recovery was achieved. On the fiscal side, the authorities can cut taxes or increase spending to support income and demand during the deleveraging phase that follows the financial crisis. But the ability of such stimulus to continue to support economic activity ultimately encounters budgetary limits. For example, the need to keep the long-term fiscal trajectory on a sustainable path limits the size and duration of federal fiscal stimulus measures. For state and local governments, the statutory requirements for balanced budgets meant that fiscal policies turned restrictive relatively quickly once budget surpluses and rainy-day funds were exhausted, and this was only temporarily mitigated by federal transfers to the states as part of the initial fiscal stimulus program. Fiscal policy is now a drag rather than a support to growth in the United States and this will likely continue. ”¦
I would add a fifth, monetary policy, while highly accommodative by historic standards, may still not have been sufficiently accommodative given the economic circumstances. ”¦
One reason that monetary policy may have been less powerful than normal is that one of the primary channels through which monetary policy influences the real economy ”“ housing finance ”“ has been partially impaired. This has both quantity and price dimensions. Credit availability to households with lower-rated credit scores remains limited and households with homes that have fallen sharply in value have lost most or all of their home equity and this makes it very difficult for them to refinance these mortgages. ”¦
Monetary policy is not a panacea
Although I favor an aggressive monetary policy in the current situation, I also recognize that monetary policy is not a panacea. We all know ”¦ that while monetary policy can help the economy return to full employment following a shock, the full employment level of output, employment and real income depends on factors outside of monetary policy ”¦
Congress and the White House should take steps that reduce the short-term and long-term uncertainty over fiscal policy. Currently, households and businesses face elevated short-term uncertainty as to what will happen to tax and spending policies in 2013 and how this will affect the economic outlook. I believe this is restraining hiring and investment today.
But families and businesses also face long-term uncertainty about how the country”™s fiscal challenges will be addressed. Providing greater clarity about the scope and terms of Social Security and Medicare must be helpful, especially in correcting those expectations that are unduly pessimistic. On this score, Social Security is particularly noteworthy. According to a 2011 Pew Research Center poll, more than 40 percent of people aged 18-30 believe they will receive no retirement income from Social Security, even though Social Security receipts are estimated to equal about 75 percent of benefits on a sustainable basis under the current regime.
Congress and the White House should enact a fiscal program that starts with mild restraint, but credibly builds that restraint over time so as to put the nation”™s debt burden on a clearly sustainable course. ”¦
Let me briefly mention a few steps that could be taken to increase the economy”™s potential over time ”“ immigration policies that attract workers with scarce skills to the United States; education policies and job retraining programs that build and replenish human capital; spending on infrastructure to remove bottlenecks; tax simplification and the elimination of tax policies that distort investment and saving decisions; regulatory policies that are attentive to costs and benefits and that emphasize getting the incentives right. ”¦
Although the outlook for the U.S. economy remains somewhat cloudy as we look into 2013, I remain a long-run optimist about where we are headed. The long-term prospects of the US economy are excellent. The United States leads the world in higher education, technology and innovation and has recently acquired new comparative advantages in energy. We have an exceptionally dynamic labor market, high rates of entrepreneurialism, competitive product markets, and a well-capitalized financial system that relentlessly reallocates capital from one sector to the next in search of higher returns.
Even over the next few years, while there are significant downside risks relating to the fiscal cliff and the eurozone, it is possible that the recovery could turn out stronger than expected.
