CBO’s Changing Predictions Show The Economy Won’t Just Heal Itself

One effect of the Great Recession was to massively widen the gap between the amount of wealth the economy could be producing and what it actually was producing. GDP production dropped almost $1 trillion from its pre-recession trend line, and between 2008 and 2011 the United States lost around $3.6 trillion.

CBO’s “current law” baseline, which assumes the nation goes over the so-called “fiscal cliff,” does not show a return to potential GDP until 2018. However, as the Economic Policy Institute noted yesterday, CBO’s predictions over the last three years have repeatedly pushed back the date of the recovery, suggesting there’s no guarantee it actually happens:

CBO’s most recent forecast shows recovery rapidly accelerating starting in late 2013, with real GDP growth averaging 4.5 percent over 2014—2016 (more than twice trend growth since recovery began); this spurt of growth exceeding potential GDP growth would close the output gap.

Should we bank on this recovery? Probably not, even though it seems that most of the deficit reducing industrial complex in D.C. is banking on it.

As an empirical matter, the CBO projections have consistently issued premature dates for when full recovery will occur; the 2014 recovery expected back in CBO’s Jan. 2010 forecast is now projected for 2018. And so on.

Part of the problem is that economies can get into negative as well as positive feedback loops. If unemployment is high and the bargaining power of employees is low, that can weigh down wage and price growth. If those grow slowly, it takes much longer for households to pay down their debt, further delaying the recovery.

But a deeper problem is that CBO’s projections of an approaching recovery don’t just build in assumptions about how the economy will behave. It builds in assumptions about how policymakers will behave as well. It assumes that the Federal Reserve responds to a recession by opening the spigot and loosening monetary policy. It assumes that safety net spending automatically increases to meet the needs of more Americans thrown into hardship.

But those policies are choices, influenced by the culture and ideology and worldview of policymakers. They are not inevitabilities, as the Republican Party has repeatedly demonstrated with its determination to rein in the Fed and impose austerity. Zooming out to the international scene, Carmen Reinhart and Kenneth Rogoff’s finding that systemic financial collapses lead to much slower recoveries is driven to no small degree by policymakers’ tendency to react to recessions with self-destructive choices. Conversely, if countries can buck the conventional wisdom that government must “tighten its belt” when individual families are tightening theirs, real good can be achieved.