This Is Why Economic Recovery Has Been So Weak

“I actually compare our economic performance to how, historically, countries that have wrenching financial crises perform. By that measure, we probably managed this better than any large economy on Earth in modern history.” – Barack Obama

So say defenders of the sluggish recovery.  But recent research belies that idea. The truth is our lackluster growth is the result of neglecting an essential economic concept.

According to Just Facts Daily, “even after the recession ended in 2009 average real GDP growth has been 35% below the average from 1960–2009, a period that includes eight recessions.” Moreover,

In early 2011, the White House Office of Management & Budget projected that real GDP would grow by an average of 3.6% per year for five years after the Great Recession (see pages 14–16). Obama’s economists noted that this figure was lower than the typical post-recession growth rate of 4.2%, but they concluded that the “lingering effects from the credit crisis may limit the pace of the recovery,” even though the recession left “enormous room for growth in 2011.” Ultimately, GDP grew by an average of 2.2%, or 39% below the White House’s conservative estimate.

Despite these unmet forecasts, some insist that recoveries from financial crises are inherently slower.  While previous economic research by Carmen Reinhart and Kenneth Rogoff appeared to affirm that notion, subsequent study has shown it doesn’t withstand scrutiny.

Harvard economists Robert Barro and Jin Tao recently conducted a major study of 185 economic contractions of at least 10 percent of GDP in 42 countries, including “financial crises such as the Great Depression of the 1930s.” They found that,

On average, during a recovery, an economy recoups about half the GDP lost during the downturn. The recovery is typically quick, with an average duration around two years. For example, a 4% decline in per capita GDP during a contraction predicts subsequent recovery of 2%, implying 1% per year higher growth than normal during the recovery. Hence, the growth rate of U.S. per capita GDP from 2009 to 2011 should have been around 3% per year, rather than the 1.5% that materialized.

Arguing that the recovery has been weak because the downturn was severe or coincided with a major financial crisis conflicts with the evidence, which shows that a larger decline predicts a stronger recovery.

So why hasn’t this recovery been stronger? The predominant explanation blames inadequate stimulus spending. It holds that more “demand” is needed to boost the economy. But this inverts the nature of the relationship between demand and economic performance. Demand is the result—not the cause—of economic activity. Therefore production, not demand, determines growth. At best, trying to stimulate demand while ignoring production is like trying to grow a flower by watering its petals instead of its roots.

But it’s often worse than that. The state can spend only what the private sector produces, which means government must first remove a dollar from the economy to spend it into the economy. Because doing so misallocate resources, the net effect is worse than zero: Rather than merely neglecting the flower’s roots, it’s like sucking water out of the soil and pouring it over the flower’s petals. Small wonder the economy has failed to break even three percent growth rates.

This basic insight was once universally understood. Writing in his “fourth proposition,” for instance, John Stuart Mill explained that “the demand for commodities is not the demand for labor”—or, as economist Steven Kates clarifies, “when you buy goods and services you are not increasing the number of jobs.” That’s because the wages paid precede the production and sale of a good or service. “The employment of labour is an entrepreneurial decision made in advance of production and sale. It is not the consequence of someone having finally bought the product,” stresses Kates. Only productive activity creates economic growth.

While failing to grasp this concept was once considered the sign of a bad economist, today it is almost totally disregarded. That’s because John Maynard Keynes, the economist responsible for our abandoning this truth is, never refuted it, although he successfully invented and repudiated a mischaracterized version of it, so that subsequent generations have been convinced of its error.

But the truth is it remains as valid today as ever. And until our policies reaffirm it we shouldn’t be surprised to witness sub-optimal economic growth rates and a weaker economy.